The Return of Depression Economics and the Crisis of 2008

  • Paul Krugman
Penguin/W. W. Norton: 2008. 256 pp/224 pp. £9.99 (pbk)/$24.95 (hbk) 9780393071016 9781846142390 | ISBN: 978-0-3930-7101-6

An often-told story about a politician — whose name varies according to the nationality of the teller — has him declaiming loudly that he is a man who sticks to his principles. But, he adds after a coy hesitation, if you don't like those principles, I have some others I could try.

Old tricks: President Roosevelt saw spending as the economy's saviour in 1938. Credit: GRANGER COLLECTION/TOPFOTO

That, essentially, is what Paul Krugman, a professor of economics at Princeton University and the 2008 Nobel prizewinner for his discipline, says is happening to economics. Rules that had become commandments — thou shalt not run a big budget deficit, nor allow the money supply to grow excessively, nor take private firms into public ownership — are being thrown away amid the worst economic downturn since the early 1980s, and possibly since 1945.

Krugman does not decry this abandonment of principles. On the contrary, he argues that it hasn't happened fast enough. For these were not laws of economics but rather creatures of circumstance that were misunderstood or misused. For more than three decades, the world's industrialized economies suffered from inflation and were preoccupied by trying to control or even defeat it. High public borrowing and rapid monetary expansion are dangerous only when they cause or contribute to inflation, which they did during the 1970s and 1980s, by adding further to demand at a time when too much money was already chasing too few goods and services.

That is not, however, the situation now. Rather than excessive demand and inflexible supply, developed economies are facing inadequate demand. That problem occurred during the Great Depression of the 1930s, and it is what Krugman means by 'depression economics'.

Online collection.

It is the topic that made John Maynard Keynes the most famous economist of the 1930s, with his book The General Theory of Employment, Interest and Money (1936). This work provided the theoretical framework for the use of public borrowing and spending to counter the insufficiency of private demand during depressions, although the practice of that policy in the United States, in the form of President Franklin D. Roosevelt's New Deal, was already under way by then. The Keynesian idea was that fiscal policy could be used to fine-tune the economy, ensuring that there would be full employment at all times. It was the misuse of that notion in the 1970s that helped to entrench inflation, which in turn made the need to restrict budget deficits seem like a fixed principle.

One of Keynes's most famous off-the-cuff remarks, which some say is apocryphal, was made when he was challenged over an apparent change of position. He is supposed to have said: “When the facts change, I change my mind. What do you do, sir?” That point is made here by Krugman, a long-time fan of Keynes. Minds should change when the facts change. Facts did change during several of the financial crises of the 1990s — in Japan, Mexico, east Asia, Brazil and elsewhere — when depressionary tendencies were seen, yet minds still stuck wrongly to the old orthodoxies.

This rigidity of thinking, when combined with a desire to believe that deregulated financial markets would be capable of learning from their own mistakes, has led to the current global economic crisis.

The Return of Depression Economics and the Crisis of 2008 is a fine piece of popular writing. Krugman avoids jargon and technicalities without leaving the already-informed reader either bored or annoyed, using homely examples to describe economic issues. For example, he makes good use of a story of how a babysitting cooperative on Washington's Capitol Hill created its own depression. The cooperative worked by giving coupons to those who babysat, which they could then use to buy babysitting services from other members; the depression occurred when too many members began to hoard coupons for later use, so that demand fell well below supply.

That, more or less, is what is happening now. Shocked by the collapse of banks on both sides of the Atlantic, households and companies are increasing their savings and paying off their debts to protect themselves against harder economic times. Individually sensible, such action to save more is collectively disastrous: what Keynes called “the paradox of thrift”. Demand is slumping, production lines are being halted, people are losing their jobs and so demand is likely to fall further. At such times when people are scared of debt, they will not borrow even if the cost of money falls virtually to zero: a 'liquidity trap'.

What to do? The weakness of this book, an update of a work first published in 1999, is that its emphasis is on the financial crises of the 1990s and not that of today. If Krugman were writing from scratch now, he would surely focus much more on the present day. However, the 11 pages he does devote to solving the current crisis make good sense: government borrowing is vital to substitute for slumping private demand, as Keynes said. At the same time, banks need to be recapitalized and have their bad debts written off to make them capable of lending again; financial regulation must be reformed to make the system more stable and to encourage people to trust it again. All that is fine in principle. But more detail would have helped readers to understand how it might work in practice.