The Return of Depression Economics By Paul Krugman: W.W. Norton & Company, New York, 1999

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1 The Return of Depression Economics By Paul Krugman: W.W. Norton Company, New York, 1999 I C R A B U L L E T I N RAJA J. CHELLIAH This book by the well-known M.I.T. Professor of Economics, written with clarity and in easy style, gives an analytical account of the severe crises that hit several parts of the international economy in the late 1990 s more specifically in the period mid-1997 to end The crises, which started as a financial one, proceeded to wreak havoc on the real sectors. The countries most affected, starting with Thailand, were in south east and east Asia, but the reverberations were felt in many other countries, though the damage done elsewhere was not substantial. At the beginning Krugman gives a brief account of the (forerunner) financial crisis that overcame Mexico in 1994 and then spread to other Latin countries, Argentina in particular. He cites the Latin American crises of 1994 as a forewarning of what might happen to even well-run economies (particularly if they are deemed as developing economies not belonging to the first world) with basically sound fundamentals, on account of sudden and large flights of capital. He argues that this lesson was not learnt and so nobody was prepared either for the emergence of a new, tequila-style crisis in Asia or for the ineffectiveness of a Mexican-style rescue when that came (p.59). What he implies is that the Mexican crisis must have alerted the economic policy makers and the managers of the international monetary system such as the IMF that such crises might recur and that they must have fashioned in the meanwhile more effective methods of dealing with and countering such crises. The IMF and others concerned should have realised that the international capital flows had become very powerful and could impact on economies with great force and that as G. Calvo suggested there are now in the globalised economy mechanisms transforming minor policy mistakes into major economic disasters (p. 58). Krugman seems to suggest that the IMF and the economic policy experts in general should have worked out more effective measures to deal with such crises. The present writer would say that they should have tried to put in place a system that would prevent the emergence of such severe crises, which could spread and engulf even economies which are following fairly sound policies. In addition to the analytical description of the meltdown of the Thai economy and the rapid spread of the contagion to the other south east Asian and some east Asian economies which were also severely affected, Krugman, of course, gives an account of the beginning and progress of the deep depression into which Japan more or less steadily sank during the He cites the Latin American crises of 1994 as a forewarning of what might happen to even well-run economies (particularly if they are deemed as developing economies not belonging to the first world) with basically sound fundamentals, on account of sudden and large flights of capital. 79

2 I C R A B U L L E T I N 80 What is intriguing is not that Japan, a fully developed economy, got into a recession, but that it was not (and even now has not been) able to get out of it through the use of some of the wellaccepted and tried methods of stimulating the economy. nineties. The onset of depression was preceded, in classical fashion, by overheating and an irrational financial boom (with, for instance, the tripling of both land and stock prices in the late 1980s). The Bank of Japan s raising of the interest rate deflated the bubble, but given the unwise investments and the risky and unsound loans, the banks failed, the prices tumbled and the real economy sank into a depression, affected also by the currency crises ravaging its trading partners and investment destinations in Asia. But Japan s recession, as Krugman sees it, is a growth recession in which a country grows very slowly, in fact more slowly than what is needed to make full or near full use of its growing capacity. There have been also years like 1998 when the Japanese GDP registered negative growth. What is intriguing is not that Japan, a fully developed economy, got into a recession, but that it was not (and even now has not been) able to get out of it through the use of some of the well-accepted and tried methods of stimulating the economy. This is the focus of Krugman s attention. While several other Asian economies suffered recession and loss in output, that was not due to underlying deficiency in demand but Japan s is clearly of that kind and of a severe variety. Demand is insufficient even at near zero rate of interest. The country is said to have fallen into a liquidity trap. In this situation, there is no room for monetary policy to try to promote demand and activity through a reduction in interest rate. The Japanese government s attempts at priming the pump through deficit spending on public works with the fiscal deficit rising to 4.3 per cent of GDP in 1996 did not yield commensurate results. That is, such spending did not help kick-start the economy, but only resulted in temporary increases in output and employment. Krugman correctly points out that mainstream economists and world leaders in general had acquired the firm belief that they had now the means and power to prevent (through quick action) the emergence of severe or prolonged depression. But such belief has now been shaken (Krugman was writing at the beginning of 1999, but Japan cannot be said to be clearly on the way to recovery even in the first quarter of 2000). Since Europe s growth is quite slow and there is unemployment there, it is legitimate to ask the question whether Europe and the United States may find themselves in similar straits (as Japan) (p. 153). This may not happen now or in the near future, but we need to keep the possibility in mind and plan out feasible remedies. Hence, the title of the book: The Return of Depression Economics. We must point out here that we are faced with two distinct problems: one is the deep depression that has enveloped a developed country which had become the second largest economy in the world; the other is the slew of currency crises (which develop into full-fledged economic crises) that have been afflicting particular developing countries and then dragging into their net several other developing countries including those whose macro-policies could not be said to have left much to be desired. As they happened these two phenomena fed upon each other in Asia, but analytically, they are to be treated separately. We shall concentrate here on the crises that overtook the Asian

3 economies. As regards the depression into which the Japanese economy has fallen, Krugman s solution is that the Japanese authorities should generate a mild inflation. Whether such a solution would be effective is not clear. However, the basic problem of the world capitalist economy is that full employment or near full employment cannot be maintained unless the economies keep growing indefinitely and so long as there is net saving. This is the problem that needs to be tackled in the longer run context. In this review, however, we are dealing with Krugman s account of the Asian crises. The Mexican crisis of 1994, its spread to Latin American countries, in particular Argentina, the east-asian crises knocking down dominoes one by one, the rather gratuitous attack on the Brazilian currency because presumably the market found a resemblance between Russia and Brazil as the budget deficit in Brazil was stubbornly high all of these have been described and analysed in detail in several writings. Krugman s account is not that detailed but it brings out the causes and the issues involved and outlines the possible solution. Krugman s account enables us to draw some important conclusions. Let us start with the three major conditions which a country would like to ensure, given international trade and a globalised capital market, for the macro-economic management of its economy. The country s policy makers wish to retain discretion in formulating monetary and fiscal policies so that they can fight recession and keep down inflation; they would like to have a stable exchange rate so that businesses can estimate with a fair degree of certainty costs and prices; and they would like to give people (citizens and outsiders) enough freedom to exchange money and invest as they like. The last is to ensure fairly free flow of capital, which would lead to investment of capital where it is needed and will be productive. All this is elementary. It is also well known that a country cannot have all the three simultaneously. There is the rub. At least one of them would have to be abandoned. There seems to be no consensus here; nor perhaps should the choice be the same for all countries. At least the weights to be given to the three objectives might have to differ. The developed countries such as USA, U.K. and the countries of western Europe have, after becoming fully developed, opted to let the exchange rate float and accepted the free flow of international capital. That is, full capital convertibility is accepted with a floating exchange rate. The market is free to allocate resources and to determine the rate of exchange of those resources. It is to be noted that these countries dispensed fully with capital account controls only about years ago. Most western mainstream economists favour full capital convertibility because it represents the free market principle and brings in all the advantages of a free market freedom to people, better allocation of resources, no or least bureaucratic intervention and hence no scope for corruption. It is obvious that if a country wants to adopt this path, it is to pursue fairly conservative (moderate) fiscal and monetary policies, (except when there is need for stimulation) and have a sound and well regulated I C R A B U L L E T I N It is not possible to simultaneously retain control in formulating fiscal and monetary policy, maintain a stable exchange rate and permit a degree of freedom on external capital transactions Most western mainstream economists favour full capital convertibility because it represents the free market principle and brings in all the advantages of a free market 81

4 I C R A B U L L E T I N 82 Adoption of a double standard only reflects the market s perception that developing countries are not politically mature and stable financial system with a low level of non performing assets (NPAs). Assume that a developing country satisfies all these criteria. Could we then say that it should prefer to adopt full capital account convertibility? By all accounts, that is what the IMF wants. With the IMF, capital account convertibility is by now an article of faith. It is my view that by virtually forcing countries in distress which approach it for aid that they should raise interest rates and deflate their economies rather than impose even temporary and partial capital account controls, the IMF unnecessarily imposed miseries on the population and caused harm to the economy. Krugman s lucid account of the progress and spread of the international currency crises of the nineties and his analysis of the fundamental causes at work enable one to formulate a rational approach to capital account convertibility vis-à-vis the developing countries, which are generally small economies in relation to the strength of the world forces at work. Krugman draws attention to a crucial fact that the international investors of capital adopt what he calls a double standard. Let us say that the market has confidence in Australia in its good governance, in the fundamental strength of its economy and in its political stability. Then if Australia runs up a large current account deficit of 5 per cent of GDP or so and is forced to let the value of its dollar come down to some extent, the market may interpret it as a good correction and then invest more in Australia. That action strengthens the dollar and confirms the market s good view and confidence. On the other hand, if even after 20 years of remarkable progress, the international market is not convinced that Indonesia or Thailand has fundamentally changed its ways and that in spite of temporary difficulties, it will continue to be a safe heaven, at the first sign of trouble, when the baht or the rupiah is devalued, the reaction is quite negative recalling the bad old days and there is capital flight, which confirms the low assessment by the market. The adoption of such a double standard is not to be condemned; it is not based on any prejudice. It is only that the perception of the market is that the developing countries are not politically mature and stable, that they may reverse policies and perhaps also that they are too small to withstand the mighty forces of international capital. Thus, the developing countries become victims of self-fulfilling prophecies. They cannot get relief through devaluation. With no real or deep rooted confidence in them why do international banks invest large amounts in debt instruments? The idea perhaps is to come in when times are good and get out quickly at the first sign of trouble. This attitude and behaviour are to be seen not only in foreign investors but also in local residents who can invest their money wherever they wish under full capital convertibility. Similar to the panic leading to self-fulfilling prophecies is contagion, defined in dictionary as transmission of disease or poison. The contagion of panic and melt down has shown a tendency to spread from the first affected country to other developing countries and create currency crises even if some of the countries were following fairly sound policies with may be some flaws here and there. The contagion did not always affect the

5 neighbour for example, the contagion moved from Mexico to Argentina, which is at the other end of Latin America (1995) and from Russia to far away Brazil (1998). If the market does not perceive a country to belong to the first class category in respect of economic and monetary management, there is risk of an attack on the system even if only the budget deficit is a little too high. It would almost seem that there are some groups controlling sizeable amounts of capital funds who are on the look out for some vulnerable economy on whose currency an attack could be launched for making quick profits. This brings us to the discussion of hedge funds. Krugman gives a faithful account of the role of the hedge funds in recent years starting with the attack of George Soros on the British Pound. Hedge funds represent speculation on a large scale. Of course, speculation as such is not illegal and is not regarded as unethical. In a sense every individual who buys equity shares can be said to be indulging in speculation. But the modern large hedge funds are not innocent speculators. They choose a favourable moment and a vulnerable and/or erring victim; to wit preferably a small or weak country whose exchange rate is out of alignment with the other relevant economic variables affecting it or some such problem. Then they employ a strategy to drive down the currency of that country: they go short or sell short in local currency and buy long in US dollars or some other assets. Thus, they will gain if the value of the local currency falls. Since they are backed by a large volume of funds, through concerted and sustained action, with appropriate noises, they create a panic about the fall in the value of the currency and bring about a flight of capital. The country holds on for some time thinking that the fundamentals are not really bad, but that only leads to a steeper fall in the value of its currency. The hedge fund does not just speculate; it employs methods to ensure that its speculation will succeed. In the case of a developed country like Britain or France, such attacks may lead only to moderate devaluation (which was perhaps needed) and no great flight of capital; but in the case of an economy which is regarded as vulnerable, there would be a self-fulfilment of prophecy and a kill. It appears that George Soros Quantum Fund was speculating in south-east Asian currencies in those years. In 1998, some funds allegedly including the Quantum Fund and Robertson s Tiger Fund engineered a drive against the Hong Kong dollar. Hong Kong dollars were sold in large blocks ostentatiously. That is, they were deliberately trying to start a run on the Hong Kong currency. Ultimately, they did not succeed because the Hong Kong authorities fought the attack off partly by raising the prices of stocks which the Funds had borrowed and also by putting restrictions on short sales. The hard fact that in the international market such Funds with plentiful resources operate must be kept in mind by developing countries in determining their policy design. The speculative activities of such funds bordering on rigging, the volatility of international capital flows and the perception of the market dominated by western fund managers and interna- I C R A B U L L E T I N If the market does not perceive a country to belong to the first class category in respect of economic and monetary management, there is risk of an attack on the system even if only the budget deficit is a little too high. 83

6 I C R A B U L L E T I N 84 If in the existing international system a very large punishment will be imposed for small crimes... then surely countries likely to be affected should to some extent insulate themselves from the system. The controls could be indirect financial controls like extra reserve requirements or physical ones, but there have to be some. tional banks that many or most of the developing countries are vulnerable justifying the application of a double standard (explained earlier), clearly indicate that as far as developing countries are concerned, full capital account convertibility is beset with risks and is premature. Of the three objectives before the country s economic managers, namely, discretion in monetary-fiscal policy, stable exchange rate and full convertibility of the currency, the first two should be given higher priority. Full currency convertibility has become an article of faith with many western economists and the IMF. While all its well-known virtues are emphasised, the risks to which a developing country exposes itself through the adoption of capital account convertibility are not reckoned. The IMF did put together a large rescue package for the affected Asian economies, but it would seem that it is not willing to contemplate any departure from convertibility brought about through any form of physical control to prevent such crises. While it is true that the free flow of capital according to market forces will generally lead to a productive allocation of resources, as against that benefit the economic loss caused by volatility and the harmful consequences resulting from the actions designed to deal with it must also be taken into account. If in the existing international system a very large punishment will be imposed for small crimes, as Calvo of the University of Maryland deplores, then surely countries likely to be affected should to some extent insulate themselves from the system. It is not a question of all or nothing. Studies have shown that comprehensive capital account controls lose their effectiveness over time (Rangarajan and Prasad, 1999). Any controls to be imposed must be restricted to the minimum. From the experience of the countries affected by crises in the nineties it appears that there have to be some restrictions (but no ban) on short and long term borrowing abroad. The controls could be indirect financial controls like extra reserve requirements or physical ones, but there have to be some. A limited amount of foreign debt liability also makes possible devaluation when needed without inordinately increasing the local currency debt burden on the resident borrowers. Foreign investments can be made free subject only to the extent of equity ownership limitations, if considered necessary on political grounds. While, as indicated, foreign fund inflow needs to be restricted only to a limited extent, outflow of capital funds owned by residents may need to be restricted more stringently. Under the present circumstances often not quite sound economic management and the real danger of steep fall in currency value residents rush (will rush) to take their money out at the slightest sign of danger. The speculative flight of capital from Malaysia was carried out apparently (largely) by Malaysians themselves (p. 126). This kind of thing has happened again and again in several developing countries. As far as India is concerned, in any case, near full capital account convertibility is to be contemplated only after all the basic conditions laid down in the Report of the Tarapore Committee are met. It appears that that is not going to happen soon! Even if these conditions are met I would urge that until it is clear that the market has confidence in us in the sense

7 that it has confidence in the U.K. or France and we become stronger and politically more stable, we should not adopt full convertibility. The kind of partial restrictions I have indicated should remain. In course of time one could begin to rely more on indirect methods like extra reserve requirements. And we should continue with the system of managed float of the currency. As for resident individuals, we should devise ways of enabling them, within limits, to invest abroad. There are already some avenues open. Additionally, such investments could be routed through the medium of some type of mutual funds. They could be closed-end funds but could be opened from time to time as the economy grows. At the same time, there should be more liberalisation in respect of current account transactions and last but not least the taming of the Enforcement Directorate. The main lesson we learn from the east Asian crises, as Krugman narrates it, is that we should have a system that would enable us to prevent a serious crisis, given fairly sound domestic monetary and fiscal policies rather than what the IMF does, namely, to concentrate on dealing with crises. As things stand, when such a kind of crisis strikes, policy makers are in a dilemma; they are often forced to recommend perverse policies, particularly if capital account convertibility is to be retained. In the Brazilian crisis of , the IMF and the US Treasury Department rushed in with a rescue plan and assistance. The plan was: raise taxes, cut spending, keep interest rates high.... It was also apparent that Brazil s politicians were being asked to do something extraordinary: to impose drastic austerity measures on constituents already being battered by economic slump, and to do so with no clear expectation that this sacrifice would receive any reward other than a possible remission of speculative pressure (p. 148). The mystery is that even after the Brazilian currency was allowed to float, the IMF insisted that interest rates should be raised. India should ensure that she never puts herself in a position to have to act on such advice. I C R A B U L L E T I N The main lesson we learn from the east Asian crises, as Krugman narrates it, is that we should have a system that would enable us to prevent a serious crisis, given fairly sound domestic monetary and fiscal policies rather than what the IMF does. References Rangarajan and Prasad (1999), Capital Account Liberalisation and Controls: Issues from the East Asian Crisis, and, No

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