Reuven Brenner
International Economy, July/August 1999
The thing that strikes one in this new, slim, book – The Return of Depression Economics – is the studio picture falling out of it. It shows the author, Mr. Paul Krugman, an MIT-based economist, resembling Mandy Patinkin of Yentl days, but with an insecure look. Maybe he is preparing himself for another career.
Judging by this book, he should.
In all fairness, Krugman himself admits by page three that he has “a private theory, based on no evidence whatsoever,” about the sudden fall of the Soviet Union. The rest of the booklet follows this same line of reasoning: Krugman presents his vague, short thoughts, and keeps them floating freely, unanchored even in simple, well-known facts.
The book pretends to provide insights into the financial crises of the last two years and suggests solutions. Krugman thinks that overvalued currencies and random, self-fulfilling panics brought about the crises. His solutions are lasting inflation (in the 3-4% percent range), devaluation, tariffs and capital controls. Briefly: Wise politicians and even wiser economists know, according to Krugman, how to compensate for the masses’ unpredictable mood swings, as well as how to price currencies.
Krugman starts his book summarizing a wonderful little article, published in 1978, by Joan and Richard Sweeney, titled “Monetary Theory and the Great Capitol Hill Baby-sitting Co-op Crisis.” Since Krugman derives his monetary philosophy from this piece, it must be summarized, because he misunderstands the story entirely. His mistakes then show up in the rest of the book whenever he deals with currency issues.
The story is this. In the 1970s, a baby-sitting co-operative with 150 couples as members, decided to issue coupons allowing the bearer to one-hour of baby-sitting. Krugman described the complicated details in a Slate piece (August 13, 1998). After a while, “few coupons were in circulation – too few, in fact, to meet the co-op’s needs.” People were accumulating coupons, rather than “spending” them. Then, the governing board decided to issue more coupons and, presto, the co-op’s “GBP – gross baby-sitting product, measured in units of babies sat – soared.”
Krugman’s conclusion: “Recessions … can be fought simply by printing money – and can sometimes (usually) be cured with surprising ease.” This is not the lesson of this case at all. The lesson is more complex, far more illuminating – and it contradicts Krugman’s views of currency matters entirely.
Issuing coupons means that a central authority, having monopoly powers – the co-op in this case – decided to issue a new currency, which could be used only to barter time. How many coupons should be issued to enable a liquid market? Assume that 75 couples wanted to go out Friday nights, while the other 75 wanted to go out Saturday night, all at the same time. If only 75 coupons were issued, and nobody knows who owns them on a particular Friday or Saturday morning, many transactions will be foregone because of the time-consuming search to make the matches. The outcome is a baby-sitting depression. However, if 225 coupons were issued, on average, half of the couples would be holding one, the other half two coupons, and less transactions would be foregone.
But notice that the printing of coupons solves here a problem only because:
– The “central bank” made a mistake first of issuing too few coupons;
– The “bank” has monopoly powers;
– There were no financial entrepreneurs within this group to create rights to coupons;
– That people preferred to forego the pleasure of going out rather than pay cash for baby-sitting services, which would come from their after-tax income.
This example has applications for monetary policy. But what it implies is:
– That more constraints should be imposed on central banks to prevent them from making big blunders to start with. It does not imply what Mr. Krugman suggests, that central banks must manipulate demand.
– That the monopoly of central banks should re-examined;
– That regulations on the financial sector may prevent finding solutions to problems;
– That finding how many coupons should be issued is hardly trivial, since it depends on technology and regulations in financial markets (with the 150 families on Internet and with sophisticated financial contracts, the number of coupons becomes almost irrelevant).
Unfortunately, Krugman’s superficial understanding of this case, which he has been using for years in his books and articles, is just an appetizer of the ignorance he displays in the remainder of his book.
Let’s begin with his analysis of the Mexican situation in 1994. Krugman says that faced with a steady drain of foreign currency reserves, the Mexican authorities’ choice was between raising interest rates to prevent the drain on foreign reserves, or to devalue. But that’s not quite what happened.
A massive printing of pesos preceded the steady outflow and the devaluation. Why did the Mexican central bank do that? And once financial markets found this out, why didn’t the bank sell bonds and absorb the unwanted peso liquidity? It’s not that Mexico’s Central bankers did not know what they were doing, or considered the consequences of temporarily higher interest rates. The story was quite different.
The Mexican government faced a dilemma. A very inconvenient one. And just before the elections. Between June 1991 and July 1992, the government sold 18 banks it owned. However, they made a mistake similar to the one US regulators did with Savings and Loans Associations. The government provided full insurance coverage for almost all depositors under FOBAPROA (Fondo Bancario de Proteccion al Ahorro). However, it did not impose regulations on the quality of loans. The consequences were as expected: delinquent loans increased, and, to keep the banks solvent, the government faced an unexpected US $70 billion bill.
Politicians faced an unpleasant choice: To tell the just-about-to-go-to-vote-public that they made a big mistake, and that mainly taxpayers – rather than the banks’ well-connected shareholders and bondholders – will pick up the tab. The alternative was to print the pesos and fulfill – nominally – the deposit insurance induced commitment. They opted for the latter. Then, once the printing presses were on their way, they tried to hide it for a while, which enabled some to take out their money at still favorable rates – an estimated US $20 billion, the loss in foreign currency that Krugman mentions. However, contrary to his analysis, Mexican insiders pulled out the money first, and not “short-term, foreign speculators.” Once the abundance of unwanted peso paper became noticeable, devaluation followed.
The government then called in the Treasury-backed IMF, who, together with Krugman, used macro-economic gobbledygook to tell the populace and the world that devaluation is the inevitable remedy. Their analyses make absolutely no reference to deposit insurance, inappropriate deregulation, political calculations or even the technical alternative of selling bonds to absorb the unwanted pesos. Krugman says that Mexican policy makers did not know what they were doing, “allowing the currency to become overvalued, expanding credit instead out tightening it when speculation against the peso began, and botching the devaluation itself in a way that unnerved investors.” How Mexican central bankers could display such astonishing ignorance with six-year regularity – perfectly correlated with elections – is an issue Krugman does not consider. Which is not surprising, the book being fact free.
Now let’s go to Krugman’s perception of Japan. According to the book, the problem there is nothing but a “financial bubble [that] … burst.” Does Krugman provide the slightest evidence? None.
He makes no reference to the fact that between 1986 and 1990 the Bank of Japan pursued a lax monetary policy, price of private housing went to exorbitant levels – which, nevertheless, did not show up either in the CPI, or the wholesale price index. The reason probably has been the inaccurate treatment of housing in Japanese price indices, because of extensive public housing and company-subsidized ones. The percentage of merged households (two adult generations living together) is 50% in Japan, and only 2-3 percent in the U.S. and the U.K. and 9 percent in France.
The lax monetary policy led to inflationary expectations – even if the official indices did not capture them. The Japanese did what people during inflationary times have done everywhere: they bought real estate, and also invested in equities – since in Japan, to a greater extent than in the US, the equities were backed by the real estate.
What then brought about the crash? Compounding monetary mistakes: The Japanese government committed a series of fiscal miscalculations. Beginning in 1988 it raised taxes: a 20% withholding tax on savings; a capital-gains tax on equity sales; a security transfer tax; a 3% consumption tax; a 6% tax on new cars; a 2.5% surtax on corporate profits, and on top, in 1990, a drastic increase in capital gains tax on real estate. The latter happened because the 17 percent capital gains tax, which came into effect after five years, was then postponed enabling it to come into effect after ten years. If one sold before, the tax was 57%. Does one need “bubbles” to shed light on why real estate-backed stocks crashed? In 1990, the government tightened its monetary policy. Now, nine years later, Japan lives with unintended consequences of this complex maze of monetary and fiscal mistakes, aggravated by the fact that its financial markets have been tightly regulated, preventing finding solutions.
Krugman makes no reference to any of these. According to him the solution is simple: Japan will be prosperous again by pursuing a 4% inflation. For how long? He does not say. Will employees just agree to a more than 20% percent drop in real wages over five years? No mention. And this is called analysis?
But it is toward the end of the book that Krugman’s lack of understanding of basic issues becomes even more troubling. He says that it is unclear why Australia can sail through the Asian crisis, whereas Indonesia cannot. His answer is that financial markets have a double standard. In a country in which they have confidence, like Australia, they buy the currency after a plunge, but they sell Indonesia’s currency when it’s currency plunges, displaying further loss of confidence.
Nonsense. Financial markets always had one standard: trust. How quickly trust is restored once it is lost, that’s a more complex question depending on the extent of checks and balances in a country. It is on these two matters that financial markets depend: trust, and speed of recovering trust if it is lost. No financial security can be created if there is not a good degree of trust. Consider for a moment the words associated with financial markets: “credit” comes from the Latin “credere” which means to trust; “bonds” are suppose to bond: “securities” assume a degree of security, which implies not just a good degree of trust, but recognition of property rights and their enforcement. No, financial markets never had two standards, only one. Nowhere is this more evident than in the sequence of events with which this book was supposed to deal.
However corrupt some governments have been – and still are – their currencies went down quickly, and came up quickly, Brazil being the most recent example. This speed has nothing to do with Krugman’s rehashing old Keyensian solutions, be they “depression economics,” “liquidity traps,” or “contagion” (Beware when economists start using the language of medicine and physics to describe facts and events of everyday living, instead of using the language of business. It means that they do not have a clue what they are talking about). The crises of the last two years have to do with making grave political or technical mistakes, and then either repairing them quickly, or giving strong signals that the mistakes will not be repeated. Arminio Fraga’s appointment as Brazil’s central banker, who was once George Soros’ partner, provides such signals. The crises had nothing to do with technical problems.
I’ll finish by commenting on a quote, which goes to the heart of Krugman’s total misunderstanding of monetary affairs. He says that “right-wing critics of IMF” are mistaken when they say that that the IMF “should have told countries to defend their original exchange rates at all costs.”
What does the maintenance of the value of money have to do with “right wing” or with ideology? “Paper money” is the government’s “non-interest paying debt.” It is a contract like all other. Why doesn’t the principle of protecting property rights apply to this particular contract? Krugman advocates property rights in the abstract, but seems to be unaware that the principle is linked to maintaining monetary standards.
At the very end of the book, Krugman says, “economic analysis is … supposed to be a way of thinking.” He either forgot how to do it, or, as can be inferred from this book, he never knew. US $23.95 – with a studio picture taken ten years ago included – may be a stiff price to pay for pompous self-indulgence passing for analyses.
Reuven Brenner holds the Repap Chair at the Faculty of Management, McGill University. International Economy, July/August 1999. The above article was reprinted in theNational Post (Canada); Straits Times (Singapore), among other publication. The article is integrated in Brenner’s book titled Force of Finance (2002)