Artful Dodger


The Return of Depression Economics, by Paul Krugman, New York: W.W. Norton, 176 pages, $23.95

Paul Krugman, an economics professor at MIT, is probably the country's most famous economist under the age of 50. In addition to knocking out interesting technical articles, mainly on international economics, Krugman writes highly readable articles and books for a general audience. His latest popular book is The Return of Depression Economics, which displays his familiar strengths and weaknesses.

Krugman's main strength is his ability to weave a complex yet understandable story about recent economic events. His main weakness, which becomes more apparent the more you read him, is his tendency to leave out important facts that undercut his view of the world. A more glaring weakness is his sarcasm and fondness for putdowns, which make it easier for him to dismiss rather than refute thoughtful people with different views.

The title of this book illustrates another Krugman weakness: his tendency, which has gotten stronger as he has gotten more famous, to exaggerate. When I think of a depression, I think of a substantial decline in an economy's output: At the trough of America's Great Depression in the early 1930s, output was 30 percent below its 1929 peak. By Krugman's own admission, Japan, the only big economy in the world that has suffered a prolonged slump in the 1990s, has had only two years of low single-digit decline in real gross domestic product.

One of Krugman's strengths is his talent for analogies that help readers understand economic reasoning. He starts with an analogy, developed by Joan and Richard Sweeney in the February 1977 Journal of Money, Credit, and Banking, between a baby-sitting co-op in Washington, D.C., and a large, complex economy.

In the co-op, people earned one half-hour coupon by providing one half-hour of baby-sitting services. At one point there was too little scrip in circulation. Couples would try to earn more scrip by offering to baby-sit. But there weren't enough other couples wanting to go out, because they didn't want to run down their inventory of coupons, and so there was an excess supply of baby-sitting services. This baby-sitting economy with about 150 couples was in a recession.

As Krugman points out, this situation is analogous to an excess supply of goods in a real economy, and thus, he concludes, it shouldn't be hard for people to accept that a much more complex economy in which millions of good and services are exchanged can suffer from lack of demand. The solution that the baby-sitting co-op finally accepted was to print more coupons, and it worked. This is like printing money to get an economy out of a recession, which also usually works.

But nowhere does Krugman mention that another way to solve a problem of excess supply is to let prices fall. This missing piece is interesting, given that it was explicitly discussed in the article from which Krugman draws the analogy. The Sweeneys pointed out that because the founders of the co-op economy imposed price controls, decreeing that one unit of scrip must always exchange for a half-hour of baby-sitting services, there would be shortages when demand was too high and surpluses when it was too low. It's not surprising that Krugman left this out: He seems to be biased in favor of having government step in rather than letting markets work things out.

Krugman explains how various countries with previously strong economies have gotten into a mess in the last few years, often prodded to so do by the International Monetary Fund. Take Brazil. Krugman notes that Brazil's economy was starting to do fairly well by 1998 as inflation was cut to moderate levels. But when speculators started expecting Brazil's currency, the real, to fall, Brazil asked for the IMF's help in defending the real's value. Harvard economist Jeffrey Sachs has pointed out that the Brazilian government could have instead let the real's value fall, and then Brazil probably would have ended up like Australia, with a currency worth substantially less but with no major economic crisis. Krugman echoes that thought.

Instead, the IMF demanded that Brazil's government keep interest rates high. The IMF also wanted Brazil to reduce its budget deficit by raising taxes and cutting spending. As Krugman notes, the main cause of future budget deficits would be the policies the IMF wanted: Higher tax rates would depress the economy, reducing tax revenues, and higher interest rates on the public debt would increase government spending. Out of nowhere, though, Krugman advocates that Third World governments impose exchange controls, which, he admits, lead to corruption and stagnation.

One of the biggest stories in Asian economies is Japan's slow-to-negative growth in the 1990s. Krugman attributes this anemic record to lack of growth in the money supply and claims that the solution is to expand the money supply in order to cause inflation. Mild inflation, notes Krugman, would motivate Japan's consumers to spend more, and more consumer spending, he claims, would boost Japan's economy. He is probably right. Interestingly, though, he doesn't consider some of the other possible causes of Japan's troubles, such as the heavy taxes on land and on capital gains that were imposed in the late 1980s and early '90s with the explicit purpose of "breaking the bubble," i.e., reducing the value of land and of Japanese stocks. Isn't it possible that the taxes worked, and that's a major reason for Japan's poor performance in the '90s?

Krugman correctly criticizes some of his fellow economists for claiming, when they are surprised by an economic change, that it was obvious all along that the change would occur. Unfortunately, he commits the same sin. In his 1990 book The Age of Diminished Expectations, Krugman wrote, "By the year 2000…Japan will have a GNP that in dollar terms is 80% or more of the U.S. level." In fact, Japan's real GNP is less than 65 percent of U.S. GNP. Krugman overestimated by more than 20 percent. Yet here's what he says about Japan's economy in his latest book: "The weaknesses of the system were actually evident by the late 1980s, to anyone willing to see."

Whenever Krugman discusses supply-side economics, he goes ape, and his latest book is no exception. He says "the specific set of silly ideas that has laid claim to the name `supply-side economics' is a crank doctrine, which would have little influence if it did not appeal to the prejudices of editors and wealthy men." In this one sentence are displayed three weaknesses that can be seen again and again in Krugman's writing.

First, note the ad hominem tactic. Krugman attacks supply-side economics by attacking the motives and objectivity of some of those who believe in it. Supply-side economics may well appeal to some prejudices of some people, but that tells us exactly zero about its merits.

Second, note Krugman's use of the words silly and crank to describe a view of the world that competes with his. That's Krugman's nasty side, which pops up whether he's attacking those to the right of him or those to his left. By dismissing the views as "silly" and "crank," he saves himself the trouble of telling his readers what is wrong with supply-side economics.

Third, Krugman's sweeping dismissal is not supported by arguments or evidence. Let us distinguish between two versions of supply-side economics. The broad version, which most American economists came to share in the late 1970s, is the view that the supply side of an economy–saving, investment, technological progress, and the size and productivity of the labor force–is what matters for output in the long run. Martin Feldstein, Krugman's and my boss at the Council of Economic Advisers (CEA) when Krugman was the international policy economist and I was the senior economist for health policy, is one of the best-known advocates of this view.

The narrow version of supply-side economics holds that high marginal tax rates discourage production by undermining incentives and that, therefore, when the government cuts marginal tax rates by X percent, taxable income increases and tax revenue falls by well under X percent. This was the view articulated by Arthur Laffer, Alan Reynolds, and other supply-siders during the late 1970s and early '80s. It is a view that Martin Feldstein shares, and it is the version of supply-side economics that Krugman ridicules.

Interestingly, some of the earliest evidence for this view was presented in 1980 by Jerry Hausman, one of Krugman's colleagues at MIT. The most systematic and careful evidence that Ronald Reagan's early-1980s cuts in marginal tax rates caused a huge increase in taxable income, thereby substantially offsetting the reduction in tax revenues, has been presented by Lawrence Lindsey. Lindsey was hired by Feldstein as the CEA's staff tax economist and was Krugman's and my colleague at the CEA during the 1982-83 academic year. Lindsey devoted his Ph.D. dissertation to the topic of Reagan's tax cuts once he returned to Harvard and wrote up his findings in the well-respected Journal of Public Economics. One signer of Lindsey's dissertation was Lawrence Summers, currently secretary of the treasury, who was also at the CEA during 1982-83. He is a man for whom Krugman generally shows much respect.

Yet Krugman mentions none of his present and past colleagues' respected academic work that supports the supply-side view. It's much more convenient for him to ignore their findings. In a 1993 article Krugman wrote, "Not all real-world questions are interesting–I find that almost anything having to do with taxation is better than a sleeping pill." Yet to appreciate the supply-siders' insights, you must delve into tax policy. Is it possible that Krugman has never taken the time to understand what supply-siders have to say?

Here's a challenge: I will give $100 to the first person who shows me anything close to a methodical examination by Krugman, written before August 1999, of the logic and evidence behind supply-side economics. You should know three things about me before you take the challenge: 1) I think I've read everything on supply-side economics that Krugman has ever written, 2) I'm a man of my word, and 3) I'm cheap.

Krugman seems to believe that the executive branch of government should have a lot of discretion in setting policy. After pointing out that the U.S. Congress refused to approve funds for a bailout of Mexico, Krugman writes: "Luckily, it turned out that the U.S. Treasury can at it its own discretion make use of the Exchange Stabilization Fund (ESF), a pot of money set aside for emergency intervention in foreign exchange markets. The intent of the legislation that established that fund was clearly to stabilize the value of the dollar; but the language didn't actually say that. So with admirable creativity Treasury used it to stabilize the peso instead."

Note his words luckily and admirable. Yet it is this same sort of discretion that, by Krugman's own admission, has often led the IMF to make things worse. Some of the best of Krugman's work supports the view, although he never says it, that discretionary government power is on balance bad. It's hard to read this book with an open mind and feel more confident at the end that giving lots of power to government officials is the best way to maintain economic growth.