Stop worrying and learn to love inflation


Today the terrible tragedy of the Great Depression looks unnecessary: our policy makers have simply gained too many tools, too much experience since then. It could never happen again. Or could it?

The world economy is not in depression; it probably will not be anytime soon. But while depression itself has not returned, depression economics - the kinds of problems that characterized much of the world economy in the 1930s but have not been seen since - has staged a stunning comeback.

Five years ago hardly anybody thought that modern nations would be forced to endure bone-crushing recessions for fear of currency speculators; that a major advanced country could be persistently unable to generate enough spending to keep its workers employed; that even the Federal Reserve would worry about its ability to counter a financial market panic. The world economy has turned out to be a much more dangerous place than we imagined. For the first time in two generations, failures on the demand side of the economy - insufficient private spending to make use of the available productive capacity - have become the clear and present limitation on prosperity for much of the world.

Economists and policymakers weren't ready for this. The specific set of silly ideas known as 'supply-side economics' is a crank doctrine, which would have little influence if it did not appeal to the prejudices of wealthy men; but over the past few decades there has been a steady drift in thinking away from the demand side to the supply side of the economy. The truth is that good old -fashioned demand-side macroeconomics has a lot to offer in our current predicament - but its defenders lack all conviction.

Paradoxically, if the theoretical weaknesses of demand-side economics are one reason we were unready for the return of depression-type issues, its practical successes are another. Central banks have repeatedly managed demand - cutting rates to keep spending high - so effectively that a prolonged slump due to insufficient demand became inconceivable. Except in the very short run, then, the only limitation on economic performance was an economy's ability to produce - that is, the supply-side.

Meanwhile, in the short run the world is lurching from crisis to crisis, all of them crucially involving the problem of generating sufficient demand. Japan is finding that conventional policies aren't enough; if it can happen to Japan, how sure can we be that Europe or even the still-booming US will not find itself in the same trap? Mexico, Thailand, Malaysia, Indonesia, Korea, Brazil: one developing country after another has experienced a recession that undoes years of economic progress, and finds that the conventional responses only make things worse.

The question of how to keep demand adequate to make use of the capacity has become crucial. Depression economics is back.

The most immediate risk from the return of depression economics is, of course, the possibility that the malaise will spread - that Argentina, South Africa, Turkey, or China will be added to the list of casualties; that deflation in Europe or a US stock market crash will create Japanese-style conditions across the advanced world. The free-market faithful tend to think of Keynesian policies - deliberate efforts by governments to stimulate demand - as the enemy of what they stand for. But they are wrong. For in a world where there is often not enough demand to go around, the case for free markets is a hard case to make.

Consider the case of Argentina. Assume, as seems all too likely, it suffers a serious recession. Now imagine that a powerful union or business group demands that the Argentine government protects jobs with tariffs or import quotas.

The conventional response to such demands is that they do not create jobs, only shift them around: a tariff can add employment in one industry but as many jobs will be lost elsewhere. In a country that has high unemployment because of inadequate demand and can do nothing to increase demand, because it fears capital flight, this argument is simply wrong. Right now, a tariff would increase employment in Argentina.

The right perspective is to realize how very much good free markets and globalization have done; the point is to preserve those gains. One cannot defend globalization merely by repeating free-market mantras as economy after economy crashes. If we want to see more nations making the transition from abject poverty to the hope of a decent life, we had better find answers to the problems of depression economics.

Even now, there are still many pundits who do not accept that the recent string of crises demonstrates a problem with the system. Instead, they point to the weaknesses of the individual countries. Japan's banks were too careless, Indonesia's ruler too corrupt, Brazil's budget deficits too large. Follow the right policies, and you will do just fine. There is no question that each country hit by the crisis turns out on closer examination to have had serious flaws. But one needs to be careful about what inferences to draw.

Imagine a highway that has recently been the scene of an unusual number of accidents. Investigators look into the causes of each accident and find some precipitating factor: the driver had too much to drink, his tires were bald, and so on. Their conclusion is that there is nothing wrong with the road; the problem lies with the drivers. But this conclusion is doubly biased. First, almost every driver or car will, if scrutinized closely enough, turn out to be flawed in some way. Second, even if they are unusually bad drivers, this does not absolve the road: good roads do not demand perfection of their users.

Similarly, a good economic system should not require perfect policies of its denizens. It is striking how many of the nations that have suffered most in recent years, from Japan to Korea, were placed on pedestals not long ago.

So what should we be doing differently? Wealthy countries tend to be blessed on all counts. Not only are they rich, but they generally have stable and effective governments. All this gives them an ability to cope with economic problems that poorer nations can only envy. Nonetheless, Japan has shown us that even advanced nations can get stuck. What can they do to protect themselves?

Japan, having fallen in its liquidity trap - unable to recover by means of conventional monetary policy, because even a zero interest rate is not low enough - and having exhausted its ability to spend its way out with budget deficits, must now radically expand its money supply. It must convince savers and investors that its current deflation will turn into sustained, though modest, inflation. Once the Japanese make up their mind to do this, the results will startle them.

The US and Europe are not in liquidity traps, so their concern must be how to avoid getting into one. The most obvious measure is to make sure that inflation does not get too low when times are good: to set a target rate of at least 2 per cent, so that real interest rates can be reduced to minus 2 rather than merely to zero if the situation demands. By that standard the United States is doing more or less the right thing, but European monetary policy is far too conservative. Finally, if crisis does strike, the rule is simple: cut interest rates drastically, without hesitation.

For advanced countries, the solutions to these problems do not seem to involve any especially painful trade-offs. There is no economic evidence suggesting that inflation at the 2 per cent rate that seems appropriate for Europe and the US, or even the 4 per cent rate I believe Japan should target, does any noticeable harm; and the things advanced countries need to do to counter depression economics do not involve any compromise of the commitment to free markets. The trade-offs facing developing countries seem more difficult.

Earlier this year, at Davos, site of that usually self-congratulatory winter soiree for the world's elite, everyone was blaming the IMF for the disaster in Brazil. But the critics disagreed with each other, it seemed, even more than they did with IMF policies.

The peculiar thing is that all of the critics could, to some extent, be right. Arguably the IMF's policy - which defends the exchange rate at enormous cost, but which neither provides a credible promise that the defense will succeed nor imposes restrictions on those who would speculate on its failure - achieves the worst of all worlds. A clear choice of any of the alternatives - a freely floating exchange rate, a currency board, or a regime of capital controls - might be better than sitting somewhere in the middle.

That said, I am skeptical of the currency board option, which protects a country from speculation against its currency but not from speculation against its economy.

The next option is to give devaluation a chance: to let the markets push your currency down. This works for advanced countries; maybe it will work in some developing countries too. What seems painfully clear from events in Brazil is that the contrary strategy, of raising interest rates to sky-high levels in an attempt to keep money from fleeing, is a losing strategy on all counts. Not only does it send the real economy into a deadly skid; by feeding investors' sense of doom, it often fails even to stabilize the exchange rate.

But what if devaluation is unacceptable, because companies have large foreign debts? Then it is hard to see how to avoid the conclusion that capital controls become necessary, as a sort of curfew on capital flight while calm is restored. Many free-market advocates will react with horror to the very idea: they believe that the right to put their money where they see fit is sacrosanct.

But just as the right to free speech does not necessarily include the right to shout 'Fire' in a crowded theatre, the principle of free markets does not necessarily mean that investors must be allowed to trample each other in a stampede.

When crisis threatens it may well be in the interest not only of the country but even of investors to impose emergency capital controls.

Still, the best thing would certainly be to prevent crises in the first place. What can be done? Nowadays everyone is in favor of more 'transparency' in the accounts of banks and companies, closer regulation of financial risk -taking, and so on. By all means let's do all that.

Beyond this, we need to find ways to reduce the strength of the feedback loops. For long-run measures my own suggestion is that governments actively try to discourage local companies from borrowing in foreign currencies.

The best way to do this is probably by taxing companies that borrow in foreign currency. In so doing, countries might regain the ability to allow their currencies to slide without provoking a financial collapse.

I don't like the idea that countries will need to interfere in markets - to limit the free market in order to save it. But it is hard to see how anyone who has been paying attention can still insist that nothing of the kind needs to be done, that financial markets will always reward virtue and punish only vice.

One of the most important obstacles to sensible action, however, is prejudice -by which I mean the adherence of too many influential people to orthodox views that are no longer relevant to our changed world. Twenty years ago, when even advanced countries were suffering from double-digit inflation and intrusive foreign exchange control was a source of major economic distortions, to preach the virtues of price stability and currency convertibility was clearly to move the world in the right direction. But we are no longer living in that world, and the useful rallying cries of one era have become the dangerous shibboleths of another.

This brings us to the deepest sense in which depression economics has returned. The quintessential economic sentence is supposed to be 'There is no free lunch'; it says that there are limited resources; to have more of one thing you must accept less of another. Depression economics, however, is the study of situations where there is a free lunch, if we can figure out how to get our hands on it, because there are unemployed resources that could be put to work.

In 1930, John Maynard Keynes wrote that 'we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand'. The true scarcity in his world - and ours - was therefore not of resources, or even virtue, but understanding.

Originally published, 6.20.99