Wednesday, June 08, 2011

Book Review (#11 of 2011)

The Return of Depression Economics and the Crisis of 2008 by Paul Krugman.
Krugman presents a pretty fast read on the international economic crises of the 1980s and 1990s and then relates those to the financial crisis of 2008. The original edition was published in 1997 and this edition is updated with a few new perspectives on those earlier crises.

By "Depression Economics," Krugman means Keynesian responses to sharp declines in aggregate demand-- increasing the money supply (lowering interest rates) and/or fiscal stimulus. He shows how successful or not those policies were in the crisis countries, and how most of the time IMF recommendations to hard-hit countries were the exact opposite-- arguably exacerbating the crises.

The subject matter was very similar to Joseph Stiglitz's Globalization and Its Discontents, which I think is essential reading, and I'm not sure Krugman does a decent enough job explaining the situations to the lay reader unless they have already read Stiglitz.

That said, I would have loved to have used this book in my International Economics/Finance course, which is really just international macroeconomics. Krugman outlines the trilemma well, but it's difficult to ascertain which of the options a country can take and not end up in disaster. It seems that all roads lead to disaster in this book--but dealing with the disaster after the fact is what matters to Krugman. The Mundell-Fleming optimal currency area criteria are outlined and skepticism about the euro very well explained.

Krugman's baby-sitting co-op reappears in this work, just as it was introduced in his Peddling Prosperity book:

A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?

Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve--then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation.

Now what happened in the Sweeneys' co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op's members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems ...

The problem is that Krugman quickly shifts from thinking about solving this problem in terms of excess cash balances into thinking about a solution in terms of interest rates. When interest rates hit zero, and people still don't go out on the town, then you're in the Keynesian "liquidity trap" that Krugman loves to say the U.S. and Japan are in.

But I think Krugman outlines the Japan crisis better than he does on his blog, clearly showing that monetary policy isn't ineffective at the zero bound so long as the central bank creates inflationary expectations-- something that Japan's central bank hasn't done in 20 years (they raise rates when there is even a hint of inflation, making deflation often more of a reality).

Krugman's explanation of the U.S. financial crisis is from a 2008 point of view, but covers most of what we now know to be a problem. His point is that the U.S. learned nothing about the real estate bubbles it saw in other countries' run-up to financial doom.

I give this book 3.5 stars out of 5. It was written for a lay person, but I think his oversimplifications might be a little much to ask a layperson to comprehend. I could use it for a class and make sure I elucidated and graphed more clearly Krugman's arguments.

Worth noting that someone who previously held my current position wrote a critique of the 1997 edition of Krugman's book for the Von Mises Institute. When asked about my opinion of the Austrian perspective, I always refer people to Bryan Caplan's well-informed article "Why I Am Not an Austrian Economist," which clearly elucidates the weaknesses and inconsistencies (and incoherence) of Austrian business cycle theory.

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