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December 7, 2008
David Warsh, Proprietor


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Lost Decade? Or Memorable Hangover?

Paul Krugman, of Princeton University and The New York Times, will deliver his Nobel Lecture in Stockholm tomorrow.  You can see the talk in real time on Monday in a webcast on the Nobel Foundation site (3 P.M. European Standard Time) or wait a few days for an online video to appear.

 

His topic is “Increasing Returns,” and, since nobody writes more honestly or better than Krugman about the experience of doing economics at its frontier, the talk will be well worth the fifty minutes for anyone who is interested and can spare the time. (His talk has nothing to do with how to recoup from the stock market crash; increasing returns is economese for positive feedback.)

 

But nothing Krugman can say from the rostrum of the lecture hall will be more salient to the present moment than what he has to say his new book, The Return of Depression Economics and the Crisis of 2008, a revised and updated version of a book of the same title (the first half of it, anyway) that he published in 1999.

 

That he’ll sell a lot of copies is certain.  Whether he will carry the day in economic journalism as he has in high economics is another question.

 

Krugman wrote the original Return of Depression Economics about the Asian financial crisis, which in the late 1990s was largely invisible to Americans, who were enjoying the dot.com mania and the Wal-Mart boom.  The US, China and Europe were growing rapidly. Who cared if Japan and several smaller Asian economies had stopped?

 

The episode was then so new that it hadn’t yet acquired a name. In headlines it was often “the Asian flu.”  Currency trader George Soros wrote The Crisis of Global Capitalism; Krugman proposed calling it “the Great Recession.” Neither name stuck, and the world economy surged ahead.  Soon enough, most of the afflicted economies would be growing again.

 

But Krugman saw the episode as the harbinger of a larger peril. The Asian experience had born “an eerie resemblance to the Great Depression,” sufficient to send a chill down the spine of anyone familiar with the history of the 1930s, he said. It had come from out of the blue; the contagion was virulent; it resisted traditional countermeasures. And in Japan, the stagnation had lasted nearly ten years – a “lost decade.”

 

If such things could happen to Japan and its neighbors, eventually reaching lands as distant as Russia and Brazil, “who knows what country could be next?”   It was as if a terrible old infectious disease, long deemed eradicated, had remerged in an antibiotic-resistant strain of bacteria. In 1999 he wrote,

 

“So far, only a limited number of people have actually fallen prey to the newly-incurable strain; but even those of us who have so far been lucky  would be foolish not to seek new cures, new prophylactic regimes, whatever it takes, lest we turn out to be the next victims.  And to do that we must first try to understand how so much can have gone wrong for so many economies.”

 

In 2008 he added, “Well, we were foolish.  And now the plague is upon us.”

 

There is no doubt about the hard times – some 1.9 million Americans alone have last their jobs this year, in a recession slowly spreading around the world. But what’s the essence of the plague? Krugman notes that the recession was brought on by a banking panic, a once-common phenomenon thought to have been eliminated as a practical concern in the years since 1945 by a welter of regulation enacted during the 1930s.

 

The seizing-up of the financial system has been transmitted to the real economy. For the first time in two generations, he says, “failures on the demand side of the economy – insufficient private spending to make use of the available productive capacity – have become the clear and present limitation on prosperity for a large part of the world.”

 

What’s the cure? Get credit flowing again and prop up spending in order to keep as much of existing capacity in use as possible.  “Good old-fashioned demand side macroeconomics has a lot to offer in our current predicament – but its defenders lack all conviction, while its critics are full of passionate intensity.”

  

The trouble with this analysis is twofold.  First, it has been outdistanced by events.  The world is already engaged in precisely the kind of a rescue operation that Krugman recommends. Keynesian economists are in charge. Critics of stimulus techniques have for the most part faded into the background, at least in the United States, if not in Germany. (There will be time later to worry about a government debt crisis in a few countries.) It is entirely possible, even likely, that the emergency repairs will work – after a great deal of damage has been done.

 

More important, Krugman ignores the trends in long-term growth both in Japan and the United States that may have brought the problem about. The proximate cause of the Japanese recession in the early 1990s was the speculative fever that developed in the second half of the 1980s, those years of dramatic prosperity when pundits were predicting that Japan would soon eclipse the American economy.

 

A more convincing explanation might turn on the fact that the Japanese economy had grown steadily and without significant interruption since the 1950s. Thirty years is a long time in which to acquire bad habits, excess capacity, and a misplaced sense of invincibility. Its crash and subsequent paralysis of political will hardly came “out of the blue.”  Krugman dismissed this “hangover” explanation in the first version of Depression Economics; he doesn’t even mention it in the second. Yet it may be at the heart of the American experience, too.

 

For the US economy grew steadily and often rapidly in the years after 1982, interrupted by only two short and mild recessions, in a world in which many other economies were also growing even faster – in which, for example, several far more efficient automotive manufacturers came online. It is easy to believe that Americans were due for a large and painful readjustment, especially after eight years of living in its own world, as its government sought to recapture the “morning in America” magic of the Reagan years.

 

Which is to say, watch out for China, when its first long boom comes to an end.

 

The most striking omission in The Return of Depression Economics and the Crisis of 2008, however, is any discussion of the Swedish experience when its real estate bubble collapsed in 1992, when swift government action reduced the number of banks to 124 from 525 and rekindled steady growth after just two years.  Outlook columnist Brenda Cronin stated the dogma succinctly this way in The Wall Street Journal last week – “The paramount lessons for nations battered by financial crises are: Act quickly, consolidate the financial sector and pursue the right balance of recapitalizing banks and isolating troubled assets. Sweden did all three, and Japan arguably did none, taking timid and unsuccessful measures for years before a new government forced sweeping action in 1998.”

 

The Bush administration was confronted in its closing months by a banking crisis brought on when a housing bubble burst – the situation greatly aggravated by the wave of financial innovation that took place after the deregulation of its banking system in the 1990s.  Exhausted by eight years of war and domestic controversy, it clearly didn’t achieve the right balance of recapitalization and bad-assets segregation, though it tried, belatedly. Next month the Obama administration will have an opportunity to try again.  This time it must deal with an extremely serious business contraction as well.

 

So how will the episode go into the history books? As “the Crisis of World Capitalism?” Another “lost decade?” Or as a memorable hangover, a wake-up call, after a long and sometimes exhilarating growth spurt that began in 1982 and that is likely to resume after a painful year or two? We’ll be a long while finding out which of these stories is most applicable. Fashioning these accounts is the business of university economists – and the political leaders to whom they give advice. That makes Krugman’s lecture tomorrow all the more interesting.

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