Books

The Return of Depression Economics

Paul Krugman

Norton, New York, 1999, xiv + 176 pp., $23.95 (cloth).

This readable little volume is directed primarily to a lay audience rather than to professional economists. It describes in nontechnical language some of the burning issues in economics, including the causes of the Mexican, Asian, and Brazilian crises; the reasons for Japan's economic stagnation; and the effects of globalization.

When the book was written, it seemed that financial turbulence and the weakness of economic activity in Asia might drag down the world economy. Paul Krugman argues that the economic policies governments adopted to address such issues have been seriously misguided, as they were in the 1930s, when actions by central banks and governments helped precipitate the Great Depression. He maintains that raising interest rates in the wake of the Mexican, Asian, and Brazilian currency crises was a mistake; that Japan should deliberately try to engineer inflation to escape stagnation; and that emerging market countries would be well advised to institute capital controls in order to insulate themselves from changes in sentiment by international investors. Thus, the problems visited on the world economy are, in Krugman's view, similar to those of the 1930s, and we can apply the policy lessons from that period-hence the term "depression economics."

Although the book remains interesting and relevant, the situation of the Asian crisis countries has improved markedly since it was written. As confidence has returned, interest rates have been allowed to decline, while exchange rates have appreciated. Prospects for growth have improved sharply in a number of these countries, as well as in Brazil, which, after an initial depreciation, saw a strengthening of its currency. These developments make it less easy to argue that the confidence-building measures Krugman decries were a mistake or that the world is in danger of returning to the 1930s. Indeed, one of the objectives of the policies of the 1930s was the creation of financial autarky. Instituting capital controls now would represent a step backward and is unlikely to be effective in the current environment, in which investors have much greater flexibility to take positions in various currencies using innovative financial instruments and in response to instantly available information.

The book does, however, argue convincingly that the crises of the 1990s were not limited to weak economies that had poor policies. Krugman shows how international investors, sometimes operating on little information, were responsible for increased volatility and indiscriminate punishment of emerging market countries through a withdrawal of capital. Some financial institutions-including, but not limited to, hedge funds-have been subject to less than adequate official supervision and reporting requirements. Emerging market governments have exacerbated the problem by giving inadequate and conflicting information about their policies, providing perverse incentives for capital inflows (such as official guarantees and discouragement of direct investment), and borrowing short term, making themselves vulnerable to shifts in investor sentiment. The official response has been to try to make international capital markets work better, not to follow Krugman in trying to insulate emerging markets from them. Consistent with this response, the international financial system is being reformed to increase transparency and the availability of data, improve supervision of financial institutions in both developing and advanced countries, and institute prudent international borrowing policies.

Though the extremes of "irrational exuberance" and gloom and doom need to be...