The perils of global finance

Published : Aug 05, 2000 00:00 IST


The Return of Depression Economics by Paul Krugman; W.W. Norton, New York, 2000; pages xxii+176, $12.95

AN international business journal has described this book as "a lucid explanation of how economies work, grow, get into trouble, and - one hopes - get out of it". I am inclined to agree, with one major qualification, though. And that qualification is tha t the description is valid if the work of economies is viewed primarily as a play of finance. I do not blame Paul Krugman, Professor of Economics at the Massachusetts Institute of Technology, for taking such a view. A great deal of what happened in the s econd half of the 1990s to the economies he has dealt with in this volume certainly was the play of finance. The problem that is dealt with in the book is the disease - the crisis, in fact - that economies that in the 1980s (and many of them even in the first half of the 1990s) were known for their "miracles" came to have in the closing years of the decade. These are the economies of Japan, South Korea, Thailand, Indonesia, Malaysia and Hong Kong in Asia, and Mexico, Brazil and Argentina in Latin Americ a. Krugman's account also touches upon Russia and China. It is the story - Krugman's narrative is exceptionally lucid - of the havoc that global finance played on these economies, all of whom Krugman credits with sound fundamentals, or strong "real" econ omies. The strong point of the book is that Krugman traces in layman's language the rise and fall of these economies, as well as the slow recovery many of them came to have towards the end of the decade. For those who wish to have a bird's eye view of th e miracles and crises of these economies, I have no hesitation in recommending this volume.

Krugman does not, of course, suggest that the problems faced by all these economies were the same. It would be strange to argue that Mexico in 1995 and Japan later in the decade, or Thailand in 1997 and Indonesia fairly soon after, confronted the same or even similar situations. Each crisis had its own specific factors, including mismanagement in some cases, corruption in some, and so on. But Krugman touches upon some common underlying factors.

The first is the fall of communism which, he says, took the heart out of the opposition to capitalism, and, again, according to Krugman, started with the Chinese reforms of 1987. "The fall of communism, by diminishing the perceived threat of radical take -over, made investing outside the safety of the Western world seem less risky than before." And so in the late 1980s and all through the 1990s a lot of capital from the advanced, capitalist countries, including Japan, moved into many Asian countries.

This movement of capital was not, in all cases, meant for long-term investment. This is the second common factor that Krugman identifies - the emergence of hedge funds, one of the most widely known among them being George Soros' Quantum Fund, which speci alise in earning quick and huge profits by taking advantage of changes in the external value of currencies and, indeed, in creating such fluctuations.

A separate chapter is devoted to the manner of operation of hedge funds that those who are not familiar with the phenomenon will find very informative. Hedge funds operate essentially by generating "self-fulfilling speculative attacks". Krugman points ou t that "modern financial markets, by creating many institutions that perform bank-like functions but do not benefit from bank-like safety nets, have in effect reinvented the possibility of traditional financial panics".

The third common factor and, in Krugman's analysis the most important one, is "the return of depression economics", by which he means the kind of demand deficiency that led to the Great Depression in the United States in the early 1930s and that formed t he central theme of Keynesian economics. The post-War achievements of capitalist economies and the frequent appearance of inflation had given the impression that depression economics was a thing of the past. No, says Krugman, using the case of Japan to a rgue the point. It is very much a contemporary phenomenon and emerges in monetised economies which make it possible for people to postpone present consumption: to hold cash instead of spending it.

TAKING these three common factors, Krugman outlines what he calls the trilemma of individual economies in the present-day global context. "There are three things that macro-economic managers want for their economies. They want discretion in monetary poli cy, so that they can fight recessions and curb inflation. They want stable exchange rates, so that businesses are not faced with too much uncertainty. And they want to leave international business free - in particular, to allow people to exchange money h owever they like - in order to get out of the private sector's way ... [But] countries cannot get all three wishes; at most they can get two."

That is bad enough. But what is even worse is that in trying to achieve two, they may invite trouble via the third. Note that this may be the fate even of economies that can claim to have their basics right and strong. Vulnerability is a built-in feature of economies that are open to global finance. "Bad things can happen to good economies," Krugman says rather helplessly.

Of the three policy measures, Krugman's preferred option is the first one - monetary policy affecting interest rates. This is because of his view that "it (the global financial crisis of the 1990s) all started with Japan", and that is true to some extent . Japan was the post-War economic miracle par excellence. No country had ever experienced as stunning an economic transformation as Japan did in the high-growth years from 1953 to 1973. There were predictions during that period that by the year 20 00 Japan would become the world's leading economy. Westerners kept wondering about the secret of Japan's unprecedented growth, and business schools in the U.S. and elsewhere started training students in Japanese management practices, believing that Japan had a superior form of capitalism.

The fundamentals of the Japanese economy were exceptionally sound. Japanese goods, especially automobiles and consumer durables, entered all countries, mainly the U.S. In the early 1990s Japan started buying real estate all over the world.

But a slump set in fairly soon. It started as a recession, a "growth recession", that is, a rate of growth not sufficient to make use of the increase in capacity that is generated. The standard (Keynesian) remedy for such situations is to stimulate deman d through increase in money supply, reduction in interest rates and so on. Krugman faults Japan's central bankers for not pursuing such policies in their anxiety to protect the value of the yen. Also, there was an increase in taxation early in 1997 to co ntain the growing fiscal deficit. And, sure enough, the economy plunged into recession. Soon the recession was passed on to other Asian economies as well.

THERE is some substance in Krugman's analysis of the Japanese and Asian crises. He is also right in pointing out that the contractionist policy that the International Monetary Fund (IMF) prescribed for the Asian economies during their crises was wrong an d counter-productive. Krugman also makes the general point that when there is a demand failure the market by itself cannot solve the problem; public intervention of some sort is absolutely necessary.

It may also be conceded that demand failure that occurs from time to time is a systemic feature of capitalism and, in that sense, whether there is a global Great Depression around the corner or not (rather unlikely, it seems to me, though financial crise s and crashes are bound to occur even in unexpected situations) depression economics must be taken seriously.

Krugman's analysis has two drawbacks. He is aware of the first one. While expansionist policies may be necessary in some instances of financial crisis, that may not be the right remedy in other situations. Frequently, interventions to prevent a capital f light (however unpalatable it may appear) constitute the proper remedy. Krugman admits that that is what helped Malaysia to turn around. More important, he admits that regulation of capital movement is what prevented the big Chinese economy from experien cing a financial crisis. Other economies, such as that of Brazil, succeeded by letting their currencies find their own level.

The second drawback is more fundamental, relating to the manner in which Krugman interprets deficiency of demand as a problem of capitalism. He interprets it solely as a deficiency of consumer spending resulting from the decision of consumers to postpone spending to the future. That, of course, can and frequently does turn out to be a problem, and expansionist monetary policy may succeed in dealing with it. However, capitalism's chronic deficiency of demand arises because private investors fail to inves t adequately when future prospects are not bright from their point of view.

This happens not because socially useful investment opportunities do not exist, but because investments may not provide the kind of profits private investors desire. Such lack of confidence appears often when investors fear that the good performance of a n economy cannot be sustained for long. This is the problem that early critics of capitalism, Karl Marx in particular, featured. Capital moves from one country to another, thus becoming global, in search of "emerging markets" and profitable opportunities of investment. And when profits in the real sectors of the economy tend to diminish, speculation becomes more attractive and capital takes the form of finance which can move about much more quickly.

Krugman glides over these basic features of capitalism and relies on a modified version of Keynesian economics. Keynes himself had indicated that there may be situations where investment may fail to be stimulated by monetary policies and low interest reg imes (the "liquidity trap") even in the short run. So, to expect the problems caused by global capitalism and the innate problems of capitalism to be remedied by expansionist economic policies is rather naive. Krugman does not even acknowledge that a dee per level of analysis is necessary to understand the frequent crises of capitalism, including their recent manifestations.

Sign in to Unlock member-only benefits!
  • Bookmark stories to read later.
  • Comment on stories to start conversations.
  • Subscribe to our newsletters.
  • Get notified about discounts and offers to our products.
Sign in


Comments have to be in English, and in full sentences. They cannot be abusive or personal. Please abide to our community guidelines for posting your comment