Copyright 1996 Council on Foreign Relations, Inc.
Foreign Affairs

July, 1996 /August, 1996
SECTION: REVIEWS; Responses; Pg. 164

LENGTH: 3185 words

HEADLINE: First, Do No Harm

BYLINE: PAUL KRUGMAN; PAUL KRUGMAN is Professor of Economics at Stanford University

SYNOPSIS: Deficit spending is not the answer to current Economic problems, and Kapstein misidentifies the problems

When a fire breaks out in a single-family home, firefighters know what they have to do. Fires in private houses are all pretty much alike. But when a fire breaks out in a warehouse, the firefighters make an effort to find out what is inside before they go to work, lest they do more harm than good. For example, if the warehouse is filled with highly flammable chemicals, dousing the building with water may spread the fire. In the end, the fire department must act regardless, but it is important to act on as much information as one can get about the nature of the problem.

I offer this homily because Ethan B. Kapstein uses an analogy with firefighting to claim that the West, faced with the economic difficulties of inequality and unemployment, has been paralyzed by too much debate over causes ("Workers and the World Economy," May/June 1996). He seems to believe that economic crises are like house fires, all pretty much the same. In particular, he seems to believe that the economic woes of advanced nations in the 1990s are basically similar to the problems of the 1930s. Deficit spending was the answer then and it is the answer now. Money should, therefore, be spent like water.

Economic crises, however, are not all the same, and the problems of the 1990s look very little like those of the 1930s. The good news is that while there is considerable dispute about the relative importance of some factors, economists have reached enough of a workable consensus about the nature of the problem to accommodate helpful policies. The bad news is that much, although not all, of what Kapstein has to say ignores this consensus, and that some of his policy recommendations are mischievous. They would either create the risk of renewed inflation and worsen the already shaky finances of Western governments, or they would contribute to the very policy paralysis Kapstein decries.


The economic difficulties of the advanced nations are not new. Unemployment in Europe has been rising steadily since the early 1970s, while inequality in the United States began rising sharply only a few years later. Nor have they failed to receive attention. Over these 20-plus years, hundreds of conferences and thousands of academic articles and official reports have addressed them. While there is not a total consensus -- there never is -- a widely held middle-of-the-road position can be summarized by two propositions.

The first proposition is that the problems of wages and employment are mainly -- forgive the jargon -- structural rather than cyclical. A cyclical economic problem is caused by inadequate demand and can be cured by adopting a more expansionary monetary and fiscal policy -- that is, spending more or taxing less. Structural economic problems cannot be solved in this way. Most economists now believe that the Great Depression was essentially cyclical; the slack in employment could have been taken up simply through an aggressive program of demand expansion. But the structural nature of Europe's unemployment was graphically demonstrated by the events of the late 1980s. The later stages of a broad business cycle recovery were marked by a noticeable increase in inflation (drastic in the case of the United Kingdom), despite the fact that the unemployment rate was still nearly nine percent. Demand had recovered, but unemployment could not fall below the nine-percent structural rate without triggering inflation.

What is wrong with trading off lower unemployment for slightly higher inflation? Not much, but that is the wrong question, because there is overwhelming evidence that inflation begets inflation. Suppose the Federal Reserve were to push the U.S. unemployment rate down from its current 5.5 percent to 4.5 percent. In the first year the inflation rate would probably rise only from its current 3 percent to 3.5 or 4 percent. But in the next year it would be 4 or 5 percent, the year after that 5 or 6 percent, and ever upward. The point, then, is not that inflation will explode if the unemployment rate is pushed too low. It is that a sustained effort to keep unemployment below the so-called NAIRU -- the non-acceleratinginflation rate of unemployment -- merely by stimulating demand will lead to an upward spiral of inflation. And though high rates of inflation would be slow to materialize, they would be equally hard to get rid of. Once the economy has developed six percent inflation, to get it back down to three percent would require a severe recession. Some countries have substantial room for demand expansion, most notably Japan. For the advanced nations as a whole, however, demand expansion is not a solution; indeed, it will only add new problems.

The second and somewhat more controversial proposition of the not-quite consensus is that the growth of international trade is not the main cause of the persistent rise in European unemployment and American inequality. Rather, the main source is a decline in the internal demand for less-skilled labor, probably driven in large part by technological change biased toward highly skilled workers. While Kapstein insists that time should not be wasted debating causes, he nonetheless finds time to pick sides in the dispute here, asserting that "as a general explanation, technology is unsatisfactory. It is never clearly distinguished from other kinds of capital, and there is no reason that its introduction must in principle reduce the wages of the unskilled."

In fact, MIT'S Robert Solow won a Nobel Prize in economics in large part for making it very clear why technological progress and capital accumulation are not at all the same -- and how to measure the difference. Since his work, in literally thousands of empirical studies of economic change, the distinction between technology and capital has played a crucial role. (My own article in the November/December 1994 Foreign Affairs, "The Myth of Asia's Miracle," was motivated by this very distinction.)

But Kapstein is quite right that technology need not in principle reduce the wages of the unskilled. Whether it does so depends on the bias of the technological change -- whether it is sufficiently biased toward skilled and against unskilled workers. But the claim of many economists that technological change is a major factor in recent wage trends is not based on a priori reasoning; it is an empirical proposition, based on facts. Nearly all industries (including those not exposed to international competition) have been increasing the average skill level of their work force by hiring relatively more skilled workers, despite the lower wages of unskilled workers. That indicates that recent technological change has been strongly skill-biased.

The conventional view that international trade is only a secondary source of the growth in unemployment and inequality is also an empirical proposition, and one not arrived at lightly. This is an ongoing debate, driven by technical issues rather than ideology. It is risky for nonspecialists to put their faith in an economist merely because they like the sound of what the economist says. For example, Adrian Wood's work, approvingly cited by Kapstein, has been subjected to devastating criticism; Wood's own numbers do not support his strong claims, and he arrives at large estimates of trade's effect only by finessing a basic calculation that indicates the opposite conclusion. n1

n1 For a detailed dissection of Wood's work, see William Cline, Trade and Wage Inequality, Washington: Institute for International Economics, forthcoming. The majority view that technology is the main story while trade is a secondary factor may be wrong, but one certainly should not take sides on this subject unless one is thoroughly familiar with the technical issues involved.

Does the distinction between internal and international causes matter? Yes, it does. Although Kapstein forswears protectionism, it is not at all clear why. After all, if international trade is the main cause of the problem, why not use import restrictions as one line of defense? But if international trade is only 10 or 20 percent of the problem, a protectionist response will bring a whole new set of problems without resolving the ones we already have.


Suppose the middle-of-the-road position on unemployment and inequality is correct: the main source of these problems is a structural, not cyclical, decline in the internal demand for less-skilled labor within advanced countries. One may then conclude that neither a simple policy of overall demand expansion nor one of protectionism against Third World imports is the answer. What, then, can be done?

This is actually not such a hard question. In the United States, which has managed to maintain relatively full employment but has experienced rising inequality, the incomes of low-wage workers need support; but that must be done, so far as possible, without raising the cost to employers of hiring those workers. The obvious answer is something like a much bigger version of the earned income tax credit -- an income supplement for workers with low earnings that falls off as a worker's earnings rise, but not so rapidly as to negate pay increases and discourage work. Such a program would be subject to some abuse, but so are all government programs.

Europe has nearly the opposite problem. The poor receive relatively generous support, but not enough people are employed. What Europe needs to do is reduce the cost of employing the less skilled, so that the private sector will offer them more jobs. But it must do so without, so far as possible, reducing their incomes. In this case reducing or removing the tax burden associated with hiring low-wage labor, and possibly providing some employment subsidies, are the obvious answers.

The important point -- on which I agree with Kapstein -- is that it should be possible to make a large difference to the incomes of low-wage workers (in the United States) or to their prospects of employment (in Europe) without devastating effects on the budget. In the United States, the crucial thing to remember is just how poor the poor are and how rich the country is. If the United States were willing to devote, say, two percent of GDP to income supplements for the working poor, the effect would be dramatic.

So why hasn't the United States tried this policy? Surely it is not because economists have quarreled over whether trade explains 10 or 30 percent of the increase in wage disparities. A better target for Kapstein's ire might be influential figures who insist that the only way to help the poor in America is to cut taxes on the rich. But Kapstein at least seems to place most of the blame on those with what he regards as a misguided, indeed mystical, concern over budget deficits.


Kapstein implies that the economic difficulties of the West are due to its governments' obsession with deficit reduction. Let me repeat that the West's economic problems have been building steadily for more than 20 years, while serious budget-cutting has begun only within the last two or three. The term "Eurosclerosis" dates not from the 1990s but from the late 1970s; European unemployment had already risen to double digits by 1985, when budget difficulties were rarely discussed. The Reagan administration took a remarkably relaxed view of unprecedented peacetime deficits during the 1980s, but that fiscal expansion did not prevent inequality in the United States from soaring.

Nor is concern about deficits the reason Western nations have been unwilling to provide more support for low-wage workers. The sums involved are small enough that if governments and voters were truly persuaded that such policies were necessary, they could quite easily be funded with new taxes or reduced benefits to middle- and upper-income families. Governments and voters are not persuaded, but that has nothing to do with the deficit.

The main reason Kapstein is eager to put aside concern about deficits seems to be that, in spite of all the evidence, he is determined to view the 1990s through the lens of the 1930s. He quotes economist Robert Eisner on the desirability of deficit-induced demand. But with the possible exception of Japan, every advanced country has plenty of room to increase demand simply by cutting interest rates. If they do not do so, it is because their central bankers think an increase in demand is unnecessary or dangerous. They might be wrong, but running budget deficits, which will merely lead those central bankers to impose still higher interest rates, will do nothing to help the situation.

Still, would a more relaxed attitude toward budget deficits do any harm? Here Kapstein's article becomes truly mischievous, by suggesting that concern about deficits is motivated entirely by ideology. Would that it were! Unfortunately, the West is past the point at which the virtues and vices of its budget deficits could be discussed in terms of uncertain macroeconomic effects. The stakes now are much cruder and more elemental: the long-term solvency of Western governments.

Debt as a percentage of national income in almost all Western nations is now comparable to the levels that historically have prevailed only at the end of major wars. But there has been no war, and instead of paying down their debts, as peacetime governments always have in the past, Western treasuries are continuing to increase their debt, for the most part faster than the increases in their tax bases. Moreover, in the current situation there are no major emergencies -- no big arms races or wars in prospect, no natural disasters that require extraordinary spending. But stuff happens. If governments cannot control their budgets when it is not happening, what will they do when it does?

The demographic time bomb makes this situation particularly worrying. The budgets of advanced countries are in large part engines that transfer money from workers to retirees, a system that runs smoothly as long as the population is steadily growing, so that the workingage population is large relative to the retired population. But Western populations have not grown steadily. Baby boom was followed by baby bust, and it is therefore certain that the demands on the social insurance systems of advanced countries will greatly exceed their resources beginning only a bit more than a decade from now. Or to put it differently, to the already huge explicit debts of Western nations one should add implicit debt in the form of their unfunded promises to future retirees. In short, concern about the budget deficits of Western nations can no longer be considered a matter of ideology. These days it is a matter of straightforward accounting, and one must deliberately stick one's head in the sand to imagine otherwise.


The aspect of Kapstein's prescriptions I found most puzzling is his insistence that a prerequisite for effective action is coordination of economic policies among the major economies. His suggestion seems to be fairly close to the textbook model for macroeconomic coordination. In that much-beloved classroom exercise, each country would like to expand its domestic demand but fears that such an expansion will worsen its trade balance or lead to a depreciation of its currency. In that case a coordinated expansion offers a way out. Increased imports are matched by increased exports, and flight capital has nowhere to go. It is a perfectly reasonable scenario in principle. It may even be a good model for the economic situation during the 1930s. But does this story about the need for coordinated expansion bear any resemblance to the current situation?

Let's get specific. Which major economies are actually constrained from expansion by concerns about the balance of payments or the reaction of international financial markets? Surely not the United States, which may huff and puff about trade conflicts but whose monetary and fiscal policies treat the trade balance and the exchange rate with benign neglect. Surely not Japan, which is worried about an excessive trade surplus, not a deficit, and which is plagued by a yen that is too strong, not too weak. Japan would actually welcome a bit of capital flight. Surely not Germany; with the deutsche mark the key currency of what remains of the European Monetary System, Germany can expect its neighbors to match any reduction it chooses to make in its interest rates. Probably not Britain; since it stopped pegging the value of the pound in 1992, Britain has felt free to follow an independent monetary policy. If it has tightened recently, it is not because it fears the reaction of international markets, but because its domestic economy is again showing signs of inflationary pressures.

What we are left with, I guess, is France, which is indeed pursuing a more restrictive monetary policy than it would if it were not concerned about the value of the franc. But the reason for France's concern is not any inherent need to keep the franc strong -- inflation is almost zero -- but precisely the commitment of the French government to the Maastricht criteria. France, in other words, is the victim of too much international coordination, not too little. So Kapstein's demand for coordinated economic policy seems to arise more from his general sense that such coordination ought to be a good thing than from any consideration of the real economic situation. Still, does it do any harm?

Whatever your assessment of the economic case, there is one overwhelming empirical observation that can be made about macroeconomic policy coordination: it never happens. Well, hardly ever. Whole forests have been leveled to print reports about the Plaza, the Louvre, the Group of Seven, and so on, but it is hard to find a single case in which a major economic player has altered monetary or fiscal policy at the behest of the other major players. One often hears about the G-7 process; the reason aficionados like to talk so much about the process is that there have been so few results.

To say, as Kapstein does, that "international policy coordination is necessary so that countries can develop expansionary policies within a collective framework," is in effect to say that real action should be postponed for years while countries engage in endless rounds of content-free summatry. Perhaps if there were a compelling case for coordinated policies there might be a way to turn these photo ops into real negotiations (although recent experience in noneconomic affairs is not encouraging), but there is no such compelling case.

None of this should be taken as a counsel of inaction. There is a great deal that can be done to improve the economic situations of the ill-paid and unemployed. However, there is no reason to tie responsible, realistic proposals to raise incomes and create jobs either to irresponsible demands for bigger deficits or to unrealistic expectations about international coordination.

GRAPHIC: Picture, no caption, WEYANT