A sickness in the body economic. The contagion that has swept through financial markets in the developing world appears to be a mutant strain immune to traditional remedies

The Return of Depression Economics

Paul Krugman <em>Allen Lane, Penguin Press, 176pp, £16.99</em>

The most worrying aspect of the recession that has swept through Asia and much of the rest of the developing world since July 1997 is not that it is new but that it is alarmingly old. We had become used, after the second world war, to putting up with recessions as a response to rising inflationary pressures. A bit of domestic overheating as demand outstrips supply? Press on the interest rate and fiscal brakes. Commodity price pressures, or an oil shock? Press harder. But the current world crisis - beginning in Thailand, then spreading through Korea, Indonesia, Hong Kong, the Philippines, Russia, Brazil, Argentina and Mexico - came out of a largely blue sky with only a few scudding clouds in it.

Moreover, the severity of the crisis is greater for those economies that have been sucked in than any other contraction in the postwar period. In Asia the only parallel is with the Great Depression of the 1930s. This is a crisis that began in a conventional way, with an overheating economy - Thailand's - but which spread in an entirely unexpected way by means of panics in the financial markets. In that respect, too, it is very similar to the crisis of 1929-31, which was the culmination of financially driven cycles of euphoria, boom and bust throughout the 19th century.

With one exception, the developed world has been remarkably untouched by this phenomenon - it has done little more than depress growth in continental Europe and hit the export earnings of commodity producers such as Australia and Canada, while the United States has powered on, the spender of last resort. The exception is Japan, which has been in stagnation ever since the pricking of its property-price bubble in 1990. The steady rise in unemployment in Japan is one of the most alarming aspects of the crisis, because some of the traditional cures appear to be failing. It is as if the virus is developing immunity to the old remedies.

Paul Krugman makes much sense on these subjects. He is one of the academic leaders of the Massachusetts Institute of Technology (MIT) faction of the economic profession in the US, as opposed to the Chicago school. The MIT crowd has kept the flame of moderate Keynesianism alive in the US, recently fanning it into something of a revival. The school is best characterised by its attempt to synthesise the old classical tradition - the belief in markets as efficient mechanisms by which to allocate resources - with the Keynesian insight that the market is prone to breakdown and can need direct policy action to fix it. Indeed Keynes himself - a Liberal with a capital "L" and a confirmed capitalist to his dying day - might well have regarded the MIT school as his true intellectual heirs.

Krugman is good at explaining the role of "self-fulfilling speculative attacks" on developing economies. Brazil, he points out, would be quite a good place to invest, were it not for the risk of crisis - that is, it would be safe for the investor if he were sure that other investors were not about to take flight. "But investors mistrusted each other . . . and the crisis came." That is the nub of the story of the crisis: individuals within the market acted in an entirely rational way to avoid losses but, in doing so, they created the very crisis they feared. When someone stands up at a football match, the people behind stand up, too. Soon everyone is standing, and no one has a better view. These collective-action problems have led to manias, panics and crashes throughout the ages. Even Sir Isaac Newton - no fool - lost his shirt in the South Sea Bubble because he thought he was clever enough to get out first.

Krugman is far less persuasive, however, in his remedies - in part, perhaps, because he has had no hands-on policy-making or analytical role, and his grasp of detail is a little shaky. He ignores the importance of prevention rather than cure and fails to highlight the crucial role of short-term debt in spreading the crisis. He does not mention the useful Chilean precedent of discouraging short-term flows in the first place by placing a tax on inward investment which becomes progressively less burdensome the longer the investment is held in Chile. It is no coincidence that Chile was the only economy in the 1982 debt crisis to be brought down solely by private sector borrowing, whereas other Latin American countries had a lot of public sector external debt. And it is no coincidence that Chile has survived the current crisis better than many nations.

Krugman warns against devaluation for those countries hit by the crisis because that can merely raise the fear of further devaluation, leading to a downward spiral. (In this respect, life is cruel for developing countries, as they are judged by different standards from those of the developed world, where devaluations are handled better.) Nor does he like the International Monetary Fund's prescription of higher interest rates to stabilise the outflow of capital and protect the exchange rate, because this leads to a deeper recession at home. So he is driven to the option of controls on the outflow of capital. That can alleviate the problem in the short term but at the expense of ruining a country's ability to attract capital in the future.

Astonishingly Krugman is silent about a preferable option: an expanded IMF. One of the reasons why this crisis has been so badly handled is that the support packages have not been generous enough to ensure that investors could get out if they wanted to, and so they are still left with a strong incentive to flee. The ideal IMF package was the sort offered to Britain in 1976 - big enough to turn market confidence on a sixpence, so that we never actually needed to draw down a penny from the fund. But the gruesome hangover of the Reagan-Thatcher years is the lingering view, in the US, of the fund as a crypto-socialist institution designed to fritter away taxpayers' money in bailing out indigent countries that ought to help themselves. The IMF has been allowed to dwindle, even in comparison with trade flows, let alone the vast new flows of capital.

Each funding increase for the IMF has to be fought tooth and nail through the US Congress, which is full of people who are slaves to the ideas of defunct Chicago economists. If the Europeans had any balls, they would offer to increase their own funding of the IMF and call the Americans' bluff. If the Americans then failed to increase their own funding, they would risk losing the voting power that gives the US Treasury an effective veto over the IMF's policies. If the Europeans were really ruthless they could combine their shareholdings and insist that the fund move to Europe, as, according to its charter, it must reside in the country with the largest shareholding. The IMF - which was Keynes's inspired idea for ensuring that the global public interest was recognised - needs reviving. Its nostrums would look a lot less draconian if it had the resources to inspire confidence and ensure an orderly adjustment to suit new circumstances.

Krugman is certainly right, however, about Japan. He essentially wants the government to cut taxes and spend more, but to fund this by printing money rather than by issuing debt. That would expand the money supply and, in his words, create expectations of inflation. As people expected prices to rise, Japan's already low interest rates would fall even further in real terms. And people would have the incentive to spend today rather than save for tomorrow. In fact Krugman's proposals are put forward explicitly as a way of creating moderate inflation. This seems designed to shock: in an economy with substantial unused resources, such an expansion of the money supply is very likely to create activity before any inflationary pressures arise. But that is Krugman all over: you don't get a reputation for being the enfant terrible of the economics business without teasing the respectable.

Christopher Huhne, formerly the economics editor of the "Guardian" and "Independent", was recently elected as a Liberal Democrat MEP. His latest book is "Both Sides of the Coin: the case for EMU", with James Forder putting the case against (Profile Books, £8.99)

Next Article