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The Return of Depression Economics

Moderator: Steven R. Ratner, Lazard Freres & Co. LLC
Speaker: Paul R. Krugman, International Professor of Economics, MIT
June 14, 1999
Council on Foreign Relations


Mr. STEVEN L. RATTNER (Lazard Freres & Co. LLC): OK. Well, I observe already—a couple of minutes behind schedule, so let’s go ahead and start, if we could. And let me just welcome everybody to this Council on Foreign Relations meeting with Paul R. Krugman, titled The Return of Depression Economics. I have a couple more introductory remarks than usual tonight. First, to welcome, as you can see on your video screens, members of the Council—not only this Council, but the Pacific Council on International Policy, the Council on Foreign Relations’ Western partner, who are participating from Los Angeles. A little bit later, we’ll turn to Greg Treverton, the vice president and director of Studies at the Pacific Council, to take a few questions from there.

Also, in a slightly different turn of events, I would like to say that tonight both the discussion and the Q&A are going to be on-the-record, and we’re going to follow a slightly different format in which, after I introduce Dr. Krugman, I’m going to ask him a couple of questions to get the ball rolling. We’re going to skip any prepared remarks, and then we’re going to, after a short while, turn to all of you to ask questions. So hopefully we’ll make this a little bit more interactive than sometimes in the past. And we will, of course, end promptly at 7:00, and we would appreciate your not leaving before we end.

Let me start actually just with a quick question to the audience, which is: How many people in this audience have a personal homepage on the World Wide Web? Nobody. Well, Dr. Krugman does. And I thought that instead of reading you the usual, you know, stuff from his PR people, I’d read you part of his Web page, because I think it’ll tell you as much as you need or want to know.

“Most people who have accessed this page probably know who I am, but for anyone else, here is a summary. I am the Forward International Professor of Economics at MIT. The title plus 85 cents will get you a cup of coffee. I was born in 1953, got my PhD from MIT in 1977 and have since taught at Yale and Stanford, as well as MIT. I also spent an eye-opening year working at the White House Council of Economic Advisers in 1982-83. In 1991, I received my major professional gong, the John Bates Clark Medal, given by the American Economic Association every two years to an economist under 40. I have written or edited 16 books, I think, and several hundred articles. Most of these are about international trade. I helped found the so-called new trade theory, which is about the consequences of increasing returns and imperfect competition for international trade and international finance and are pretty well incomprehensible to laymen.”

“However, since I wrote The Age of Diminished Expectations in 1989, I have increasingly tried to communicate with non-economists through op-eds, magazine articles, and so on. It turns out that people have a hard time tracking all this stuff down, hence, this page contains, among other things, links to my two monthly columns, ’No Free Lunch’ in Fortune and ’The Dismal Science’ in the cyberscience magazine Slate. With any luck, you will find many of these pieces extremely annoying. My belief is that if an op-ed or a column does not greatly upset a substantial number of people, the author has wasted the space. This is particularly true in economics, where many people have strong views and rather fewer have taken the trouble to think those views through, so that simply insisting on being clear-headed about an issue is usually enough to enrage many, if not most, of your readers.”

We’ll see how he does with the audience. And if any of you want more, you can turn to his Web page. I would also tell you, I did also encounter the fact that The Economist magazine selected the five best economics Web pages in cyberspace, and Dr. Krugman’s ranked second. Actually, next week the best website is going to be represented here.

I think you all, I’m sure, are aware of many of the areas in which Dr. Krugman has spoken and written. And, of course, within these walls, he’s particularly famous for his article several years ago anticipating the events in Asia that we’ve all now become too familiar with. And I’m sure Asia will be a subject of conversation. And before I start, the only other thing I would tell you all is that I also discovered that Newsweek magazine has once described him as “gnomishly handsome,” whatever that means. So we’ll find out what gnomishly handsome means.

As I think everybody divined by the copy of the book outside, the title of this session is not unrelated to a new book that Dr. Krugman has just published, as well as an article that appeared in the January/February issue of Foreign Affairs. So let me maybe start with that and give us a chance to talk about what’s been on his mind most recently.

I think if it’s not a gross oversimplification, for those of you who haven’t had a chance to read out of the book or the article, the thesis is that we’ve returned to a world of classical economics, of austerity policies and liquidity traps, both of which, of course, characterize the worldwide Depression that occurred in the 1930s. What I’d like to do by the way of a jumping-off point is to ask you to take a look at the world as it is today, which does move in Internet time, and capital probably moves even faster, and ask you if you still see the world as grimly as you did a few months ago when you wrote the book and also the article. I happen to have been struck the other day that however unpleasant the past year has been, to see a forecast that predicted positive real GDP growth, I think, in every Asian economy except Indonesia—and we’ll put Japan aside for the moment—and I think that would cause one perhaps to contrast what you saw happening over the past year in the case of these disruptions, which is what happened in the 1930s, which was obviously not just a return that hit the developing world, but also one that hit the developed world and lasted quite a number of years.

So I thought that—I’m sure you can express the book thesis better than I can, but I think it would be helpful perhaps if you wanted to start out by updating us on how your thinking has evolved in light of some recent progress in the rest of the world.

Dr. PAUL KRUGMAN (Professor of Economics, MIT): OK. Well, the title of the book was careful. It’s a four-word title, not a three-word title. It’s The Return of Depression Economics, not The Return of Depression, and it wasn’t a forecast that everything was going to go to hell immediately or necessarily ever. And what I would say is that this is still a world which has got a lot of depression-style economic problems in it. Japan, which for me is in some ways the centerpiece—Japan can be the scariest place on earth—is plateauing, holding level only through enormous fiscal stimulus at a rate they can’t maintain. They just can’t keep on doing this. And there’s no sign that they’re really broken out. And I view Japan as an omen in some respects for the rest of us.

The Asian economies have bottomed out. They’re growing. That, I actually more or less expected—maybe a little bit better than I thought. But when they get back to something like a 5 percent trend line projected from where they were, then we can actually call it a recovery. The only really good news, I think, is Brazil, which has turned out to be a much better story. But I’m still spooked. I think that it’s kind of alarming, actually, how quickly people have been willing to take the fact that the world didn’t end this time around to say, “Oh, well, we must have the situation under control.”

Mr. RATTNER: Well, you mentioned Brazil, and one of the things that you talk about in the article and in the book is—and going back to the depression economics—is the role of austerity policies. And I think you said a lot about the role of austerity policies. Is Brazil an example of a case where austerity policies actually work? We have a recession that’s much shallower—I think down 1 percent last year—than people expected and low inflation and interest rates that are coming down.

Dr. KRUGMAN: Actually, no. I describe Brazil—Brazil is a case where it turned out the austerity policies were unnecessary. I mean, the story of Brazil is that in the fall the International Monetary Fund (IMF) imposed a program which was almost a caricature of its programs in Asia. It was almost as if we the textbook about what do you do in the face of a slumping economy, took the older recommendations from the textbook and did the opposite. And they did all of that to safeguard the value of the real, which was thought to be absolutely sacred; terrible things would happen if it was knocked off its peg. And then—thank God—it was knocked off its peg. And it’s turned out that the Brazilian economy, much more so than the Asian economies, is resilient to that, that that devaluation is starting to look like the best thing that every happened to them. And that’s wonderfully good news. It means that not all emerging economies are as vulnerable as the Asian economies turned out to be. But, no, I mean, the reason why things are better in Brazil is not because they did the austerity programs, but because finally, at least on the monetary side, they abandoned them.

Mr. RATTNER: So you basically—perhaps you could expand just for a minute for this group on your view of the austerity policies in Asia and anywhere else in terms of the appropriateness of them, because I’m not sure whether everybody has read the article or the book.

Dr. KRUGMAN: Yeah. I’m not one of these people who thinks that the IMF is evil and was trying to—you know, did everything wrong. The way I would put it is to say, first of all, that much of what the IMF did, I would have done if I were in that place at that time. You know, if you have one MIT professor running things, it’s probably not different from another. But what I would have said is that in Asia, there were no good alternatives. It was a Hobson’s choice, that we managed—which we may or may not want to get into—we managed to get these Asian economies into a situation where they were just enormously vulnerable to a panic on the part of investors. And anything they did—if they let the currency go, then they’d have a financial collapse because balance sheet effects. If they defended with high interest rates, then they’d have an economic collapse because of high interest rates. There were no good answers. And you could talk about the details, but the main point is either don’t get into that situation or break the rules of the game when it happens. Well, leave it at that.

Mr. RATTNER: And breaking the rules of the game would have involved what?

Dr. KRUGMAN: Well, actually, it’s interesting. What you had was a panic. Essentially you had a stampede, a situation in which investors en masse were fleeing the country because they feared economic collapse and, by fleeing, were bringing on the economic collapse, a vicious circle of lost confidence. Breaking the rules at that point means, instead of trying to somehow persuade the investors to stay and inverting all of the normal things you might do to fight a recession, you instead find some way of insisting that they stay.

Now it turns out that Korea, which is the best story, the most convincing recovery, actually, we did that. While talking free markets, in fact, we corralled the bankers into maintaining their positions, and that is probably crucial in their doing so well. But beyond that, the only thing that—I actually think now that that was probably the more viable alternative than I thought six months ago. But basically first line of defense is, if you’re in that kind of stampede, to get the creditors together, concerted action. And if that doesn’t work, then capital controls.

Mr. RATTNER: Which you, I think, advocated—Wasn’t it? —in Malaysia...

Dr. KRUGMAN: Yeah.

Mr. RATTNER: ...and you were somewhat misinterpreted, and people thought that you simply said capital controls, and I think what you really said was capital controls in the context of appropriate other policies.

Dr. KRUGMAN: Yeah. I mean, follow the—no, let me bash myself a little bit. My timing was horrific. I came out for the capital controls just at the point when the stampede was starting to let up anyway, and that’s an occupational hazard. But I think the case was still there. The other thing I would bash myself for is to say that I took the evolution of financial markets to its logical conclusion, which is that there’s this vast pool of capital. All of it is potentially capital flight, so just dealing with the banks isn’t effective. Well, it turns out that that’s the millennium, and the millennium isn’t quite here, and dealing with the banks probably is effective in most cases still. It won’t be in 10 years, but it is now. And so, something like the Korean solution worked.

But, yeah, if you cannot say—if you buy the diagnosis that what you really had was stampedes, self-fulfilling financial crisis, then you have to say that, under some circumstances, closing the doors until people—imposing a curfew until people calm down is, in fact, good policy. It’s not a violation of the basic principle of free markets. It’s a justifiable emergency measure.

Mr. RATTNER: We’re going to come back to that in a second. Let me go to Japan before we do that and ask you, before I ask a Japan question—because this is where the liquidity trap comes into play. And I don’t think everybody in this room is probably an economist, so maybe you ought to give, rather than my getting a failing grade from you...


Mr. RATTNER: ...a quick definition of a liquidity trap.

Dr. KRUGMAN: A liquidity trap is when zero is not low enough, when you reduce the interest rates that are under the direct control of Alan Greenspan or his equivalent all the way to zero, and that’s still not enough. And at that point, conventional monetary policy has got no more traction. If you don’t have something else you can do, then you’re in a situation where the economy remains depressed. There’s not enough demand, maybe even a deflationary spiral. It was last seen in the 1930s. I think the general view of economists, myself included, was that it’d been so long, that we’ve concluded that it can’t happen, it didn’t happen and it won’t happen again. But there it is. It’s the world’s second largest economy, and it’s squarely in a liquidity trap.

Mr. RATTNER: And I think you’ve suggested that the solution to that is to raise inflationary expectations, so that, in effect, people will spend money before it’s worth less tomorrow. I think that’s my—one of my questions is: In a world of, you know, .02 percent interest rate or whatever, how do you create inflationary expectations without being able to lower interest rates anymore?

Dr. KRUGMAN: Well, the first thing is you rely—it’s a credibility problem. Japan is in the “Alice through the looking glass” world of monetary policy, where they have a credibility problem, and the problem is that they cannot convince people that they’re going to be irresponsible. They need to credibly promise to be irresponsible. They need to promise that there will be inflation, not a lot, but 3 percent, 4 percent, over the next five years. And basically people don’t believe them. No matter how much money they print in the ordinary course of events, people think, well, you know, they’re just going to revert to being central bankers at the first chance and try to stabilize prices. And so people just hold onto the money, because when the interest rate is zero, cash and bonds are the same thing.

So what can they do? Well, one thing is simply to announce it. I think if the Bank of Japan actually were to announce, ’Well, we think some inflation’s a good thing,’ that would catch people’s attention. That would, I think, affect expectations. The other thing, there’s a whole series of things they can do up to the final—I was about to say the nuclear bomb here, but I probably shouldn’t say that for Japan—but, anyway, the ultimate weapon there is to directly monetize the government deficit. I don’t think they’re going to need to do that. But that’s held in reserve as the ultimate thing. And what I would say is they should announce the target and then say that, “We will persist until we prevail, and we’ll steadily widen the actual operations.”

Mr. RATTNER: Well, obviously, we’ve been talking about the demand side in Japan, and that has been your focus and that of some other people. But one could also talk a little bit about the supply side, and particularly the idea of efficiency and productivity and other problems in the economy. And I think some people also are saying that what Japan needs is not simply a dose of demand. That would be a very temporary kind of stimulus, much like we tried in the 1970s and other times. What Japan needs is a very fundamental restructuring of their economy that can only really be accomplished by a period of downsizing or whatever you want to call it, much like we’ve been through in this country over the last 20 years. And, therefore, simply creating inflation or inflation expectations and boosting demand isn’t going to really solve their problems.

Dr. KRUGMAN: I think of Japan as being like the United States in 1982. Actually, it’s roughly in as deep recession as the United States was at the bottom of that recession. And that was—the U.S. economy had a lot of structural problems 17 years ago. It was, you know—we had clumsy, inefficient giant corporations. We had still excessively powerful unions. You know, there were a lot of—we had very sluggish productivity growth. All of those things needed to be addressed. But addressing them wouldn’t have solved the fact that we were also operating 10 percent below capacity, because there just wasn’t enough demand. And that’s the situation in Japan right now.

Efficiency and good business cycle performance are not the same thing. You can have a very inefficient economy that’s got full employment and a lot of stability, like Britain in the 1950s and 1960s. Or you can have an extremely efficient economy, the best in the world, that is extremely vulnerable to a business cycle crisis, like the United States in 1929. And Japan is some of both. They’re inefficient, and, by all means, they should address that, but especially if they do it now. They’re doing a lot of restructuring, shedding excess workers in the face of what’s already an economy with a lot of deflationary pressure. They might make their microeconomics better, but their macroeconomics will get even worse than it is now.

Mr. RATTNER: Look, obviously, it is a balancing act, and it’s a question of, also...

Dr. KRUGMAN: Well, it’s both.

Mr. RATTNER: Yeah.

Dr. KRUGMAN: Tandem.

Mr. RATTNER: Right.

Dr. KRUGMAN: You know, I actually—you know, some people think that bad macroeconomic situations are good for reform. I think the reverse. I think you’re much more likely to succeed in reform if you also have enough demand so that the economy can make the transition so that there are jobs.

Mr. RATTNER: Not to paraphrase, it depends on what the meaning of ’bad’ is, I guess.


Mr. RATTNER: Let me turn to Europe for a second. The euro has not been, I don’t think, one of your areas of principal focus, although I think I’ve seen you quoted as saying...

Dr. KRUGMAN: Over the years, I’ve done a lot about the euro.

Mr. RATTNER: Excuse me? All right. Well, then you’ll tell us all about it. I think you...

Dr. KRUGMAN: You know what we call experts in the euro?

Mr. RATTNER: Excuse me?

Dr. KRUGMAN: Experts on the new European currency are eurologists, obviously. Anyway, sorry.

Mr. RATTNER: Well, I’ve sat through a lot of euro meetings. I never heard that before.

Dr. KRUGMAN: Sorry. Couldn’t resist that.

Mr. RATTNER: That’s good. That’s good. But you have said, I think, that—and maybe a lot more, but at least the piece I did notice was you saying that you didn’t think the ECB had used monetary policy aggressively enough in terms of lowering interest rates more. But let me again—it’s, I guess, a little big of an analogous question to the Japan question—let me ask you again in the case of Europe whether that’s enough. And I think, you know, there are several things one could throw out. First, is Europe really a common currency area, particularly without putting fiscal policy, tax policy into the mix? And, secondly, I guess, again an analogous question to Japan, have the Europeans kind of latched onto the euro as a sort of lifeboat to avoid making a lot of other tough decisions in terms of restructuring their own economies, labor policy, social policies, and so forth?

Dr. KRUGMAN: Your second question first, I mean, the thing that always strikes me about Europe is that they took this project, and it became the be all and end all of everything. And it was, I think, among other things, just an excuse not to deal with everything else that they needed to deal with. Remember when Donald Tsang from Hong Kong came through, he said, “Everyone in the world wanted to talk to me about Hong Kong and what was happening there, except the Europeans, who only wanted to talk about the euro.” So, you know, it’s—I mean, I suspect that we’ll never know for sure. I think the euro’s probably a bad idea. It’s not a critically bad idea, but on balance, it probably does slightly more harm than good. But you’ll never get to make a clean test of that.

What the situation in Europe is that they have big structural problems. I’d be willing to concede that it’s probably true that no matter how much demand stimulus you give the European economy, it’s going to be left with an average unemployment rate of 8 percent or 9 percent, and that’s because of sporadic labor markets and, you know, all the usual things. And they certainly need to make progress on that. But the actual...

Mr. RATTNER: That sounds eerily reminiscent of what they said about the United States in the 1970s.

Dr. KRUGMAN: Well, that’s right. First of all, you don’t know until you try, right? The current unemployment rate is 11 percent. And that means that there’s a lot of slack. Yes, most of the problem is probably structural, but we don’t know that. And, sure if there’s been one lesson from the Greenspan reign, it’s that you don’t know how low unemployment can go until you give it a chance. You know, fire when you see the white of inflation’s eyes. But Europe is actually, if anything, drifting toward deflation. And I think I understand the immobility of ECB, but I think it’s really wrong.

Mr. RATTNER: I can’t let you get off that without—when you said the Greenspan reign, as opposed to the Volcker reign, the Reagan reign, the Bush reign, the Clinton reign, the Rubin reign. Is it the Greenspan reign?

Dr. KRUGMAN: Yes, it’s the Greenspan—look, I think, give him enormous credit here. Ninety-nine out of one hundred central bankers faced with this ongoing expansion, the unemployment rate dropping into unprecedented territory, would have said that even though they didn’t actually see anything in the inflation numbers, it just wouldn’t be responsible to keep the reins loose. And Greenspan was willing to take the risk that inflation might pick up a little bit to explore the territory, and it’s turned out to be tremendously productive.

Mr. RATTNER: But isn’t it fair to say the foundation for that was laid either a long time ago under Greenspan or before that even in terms of an economy that could operate at 4.5 percent unemployment?

Dr. KRUGMAN: Yeah, we have no idea why we can do that. All right? Is that—who’s got all the answers, you know? Well, I mean, I’m not—there’s a very careful paper by Larry Katz that goes through, and I thought that we couldn’t explain why the unemployment rate can be so low, and Larry says that very definitely we can’t explain it. After carefully taking into account of all the factors, we’re left with most of it unexplained. Something has mysteriously gone better.

Mr. RATTNER: At least we don’t have to read that paper. We know the answer. Before I turn to the audience, let me deal with one other obvious subject, which is we’ve had a change in leadership at the Treasury. And let me start with Bob Rubin. You were quoted on Sunday as saying about Bob Rubin, ’Rubin was something like an old family doctor in the days before antibiotics. He knew that even if there was not much he could always do, most things get better over time. So the important thing is to have a good bedside manner and help people through it.’ So let me ask you to grade him, though, not just on bedside manner, but to get into substance. And particularly in light of some of your earlier comments about some of our international policies, how do you grade Bob Rubin?

Dr. KRUGMAN: It’s funny, because the things that he’s most identified with, which is the international, is actually where Treasury secretaries don’t have a lot of direct impact. I would say probably, if you really sat down and did it, probably, an MIT-type grading, A-/B+, because there are some serious mistakes. I could say that we—there’s too much detail, but we screwed up. We fired a shot across the bow of the Japanese when they wanted to set up a special Asian rescue fund, which turns out would have been very useful, and that was Treasury playing amateur geopolitics, and that was a big mistake. I think we screwed up—you know, there are a number of details where things could have been better. There are also places where it clearly could have been worse. But he presented a good, calm front.

On domestic policy, there haven’t been a lot of dramatic things done. They’ve all been sensible, so I guess it’s an A, but it’s an A in sort of an easy exam. But, you know, on the manner, it’s—sorry, I really have something I should say here.

Mr. RATTNER: I’m not sure that’s how he sees it, but...

Dr. KRUGMAN: No, but, look, we are—actually, one of the things that scares me about our economy is that we depend so much now on charismatic leadership. You know, who knew what Willie McChesney Martin was like or what he did? Can you even name the Treasury secretaries of the 1960s? It didn’t matter. We had an economy that was very stable, very easy to run, without that. Now we depend upon heroes. And Rubin did a wonderful job of providing that moral charismatic leadership that we needed, and so on that he gets an A++.

Mr. RATTNER: Fair enough. Let’s move on to the other MIT professor, as you described him, Larry Summers. Let me...

Dr. KRUGMAN: I was actually talking about Stan Fischer. Larry’s a Harvard professor.

Mr. RATTNER: Harvard professor, that’s right. Fair enough. Let’s move on to Larry Summers and let me ask you to look ahead and give us some predictions as to what we should expect from him. But let me, rather, make it so generally, point you at two things that may be worth your commenting on. One, Larry has, I guess in his academic life, talked about how a little bit of inflation can be a good thing. And you’ve said some of the same things in your book about it gives you the ability to lower interest rates below—or .20 or below zero, I guess, in real terms. Let me ask you whether we can expect any of that from him.

And, secondly, let’s talk just a bit about the dollar. And there’ve also been, I think, in his past hints that he’s not quite as focused on a strong dollar as Bob Rubin was and, I think, there are hints—you said things in the same vein that a strong dollar isn’t always the right policy for the United States. So maybe you can mix your own views with what you expect from Larry.

Dr. KRUGMAN: I would expect none of this to be operational; that is, the United States is not faced with those choices. We don’t really have a choice on—we’re not in a liquidity trap. And barring, you know, an abrupt crash in the market, we’re not going to be in a liquidity trap anytime soon. And if there is an abrupt crash in the market, then we’re going to really find out what kind of material Larry is made of.

And as far as the dollar is concerned, now we don’t really have a dollar policy. It always amazes me that people talk as if we did. We did have a brief period when we were trying to talk up the yen as a way of intimidating the Japanese, but that’s in the past. And aside from that, we basically have a policy of benign neglect in which the Treasury secretary’s expected to say that an appropriately strong dollar is in U.S. interests. And, sure, whatever that means.

Mr. RATTNER: Well, you know, although in Rubin’s exit reviews, one of the things people have given him the A+ for is the strong dollar mantra and the leadership on the dollar, to use your phrase from a few minutes ago.

Dr. KRUGMAN: Yeah. I find it hard—I guess that’s where I really find it—I don’t really quite know what’s meant by that. In fact, the one thing I will say is that it appears that this Treasury Department is now willing to at least be tolerant of a weak yen policy, which is not quite the same thing, because there we really are talking about radical monetary policy. So, sure, I mean, we’re not going to—I don’t think Larry’s going to bash the Japanese if they do do policies which, incidentally, weaken the yen. I don’t think he’s going to yell at the Europeans if the euro slides below one. So I guess in that sense, he’s a strong dollar guy.

Mr. RATTNER: So you don’t see any even nuances of difference that we should look for under the Summers reign?

Dr. KRUGMAN: You know, I find it really hard. It’s turf theory. Where you stand depends on where you sit. And I think it’s very difficult to imagine that any significant departures are going to happen, at least not in the next 18 months.

Mr. RATTNER: Fair enough. OK. Well, on that note, why don’t we turn to the audience, and let me remind everyone to state their name and their affiliation and to keep your questions brief. Paul Krugman has done a great job of keeping his answers short, and let’s keep going, and we’ll get a lot in. Who’d like to ask the first question? Nobody. OK. Yeah.

Mr. RATTNER: I think we need the mics because of the folks in Los Angeles.

QUESTIONER: Could you please comment on Rubin’s parting shot that if we take tax breaks, we really have blown it?

Dr. KRUGMAN: Boy. I have to admit that I actually missed that one. Was this comment that if we start cutting taxes because of the surplus?

Mr. RATTNER: Essentially, yeah.

Dr. KRUGMAN: Yeah. I mean, I’m not an expert on these things, but my understanding is that among the many mysteries, not only is the economy running far hotter than we thought it could without inflation, but we’re also getting about $60 billion a year more tax receipts than the standard models predicted we would, even at this level of economic activity. And we do have, as Pete Peterson would point out, we do have a long-term demographic issue. So, sure. One of the reasons why we’re in better shape than the Japanese is that we have a nice healthy fiscal situation so that we can, if we need to, we can run deficits when it becomes possible. I wouldn’t want to see us throw that away at a time when the economy is still booming along.

Mr. RATTNER: Next question...

QUESTIONER: Paul, as once upon a time secretaries want to do, reflecting on my time there, it seemed to me the decisive moment was the Deficit Reduction Act of 1993, and on that, Bob Rubin gets an A+ as far as...

Dr. KRUGMAN: Yes. I should have said that.

QUESTIONER: The question I wanted to ask you to comment on was Indonesia, which I didn’t see identified as the one place that’s not seen much improvement yet. And what do you foresee as the future in Indonesia?

Dr. KRUGMAN: That’s a very hard question, and the reason is that it’s basically political. In terms of the economic fundamentals, Indonesia was actually—by general consensus, Indonesia deserved the crisis in terms of economic fundamentals less than almost anybody. And right now, although there is an economic problem, or it’s sort of an economic problem—and basically, Indonesia is a wasteland of destroyed balance sheets—there are basically no solvent large corporations and so there’s sort of this unresolved morass of claims.

Nonetheless, there’s a lot of potential vitality there. There’s a lot of smaller firms that are doing quite well. There’s a lot of export potential. The reason that Indonesia is not sharing the bounce is the politics, and I have no insight. I don’t know what the answer is. It’s one of those countries like Russia, where I can’t—things can’t go on like this, but I can’t see how they can end either.

Mr. RATTNER: We’re going, I think, take a couple questions from LA now. I don’t know—has it just happened?

QUESTIONER: Yeah. Thanks, Steve. No. This is a great experiment. It is, as you know, the middle of the afternoon for us, so we get to finish and be dumped into rush hour traffic, speaking of dismal sciences, but this is really a tribute, I think, to the subject and to Dr. Krugman. Let me abuse the privilege and ask the first question and turn to my colleagues. You have been interestingly prescriptive about almost everybody except the United States, and I wonder in your piece, you march toward some recommendations but rather stop short of them. Other than being nimble and avoiding doing bad things the next time around, is there anything the United States ought to be doing that it isn’t or ought to stop doing that it is, as you look on this international economic conjuncture?

Dr. KRUGMAN: OK. I mean, if the first question is—so the standard instruments monitoring fiscal policy, I think the United States has got the best policy mix, the most sensible, most flexible policies that anyone has here. I’m sorry if I’m looking a little—it’s helped me realize that looking at your image on the screen doesn’t actually give you the opportunity to see me, but anyway, the virtual versus the real...

Dr. TREVERTON: We do get to see you, though.

Dr. KRUGMAN: But, no, I was even a little surprised at what the Fed did today, the open mouth operation that the Fed launched today because it seemed to me that watchful waiting is still the natural policy. I’ll tell you what I think should be done, but this book sort of had to be written relatively—you know, had to be written now, and I’m not quite sure I know the details. I know I don’t know the details.

It seems to me that we have—last fall was very scary. OK. There was that period of several weeks when the U.S. capital markets just stopped, when we had what was the functional equivalent of a bank run, but it didn’t involved anything that was called a bank. And we got out of that by the skin of our teeth. Basically, Alan Greenspan got on his horse—you know, the army was starting to break, he rode out on his horse in front of it, waved his sword around, shouted something incomprehensible, and morale was restored, and that was well-done, but not something you want to count on.

And what I think that episode revealed was that our financial system has outgrown or maybe the right word is outflanked the protections that we have. We have a sort of imaginary lines to protect against banking crises—you know, multiple layers of defense, regulation, deposit insurance, and the Fed’s explicit lender of last resort role. And that was fine 30 years ago, but now we have this vastly more sophisticated complex banking system in which—financial system in which many of the traditional banking roles are fulfilled by non-banking institutions that are completely outside the defenses, and I think we ought to be looking for ways not to regulate the system back into the 1950s, but ways to extend the kinds of protections that we have beyond that.

At that point, I’m starting to run into the limits of my expertise because financial regulation is a very difficult and technical subject. So I think it ought to be being studied urgently now, and that’s what we’re not doing. I don’t have the specific recommendations.

Mr. RATTNER: Do you have another question from LA?


QUESTIONER: Yeah. Paul, my question—you mentioned briefly Russia, and I’d like to come back to that. You said at the outset, your title is The Return of Depression Economics, not The Return of Depression. But in Russia, we’ve seen a real depression comparable to ours in the 1930s or the Myanmar Republic or other instances. And partly, it was due to their own mistakes. Partly, they took bad advice from the IMF and World Bank; partly, the poor leadership with a Hoover-type president who just fired the one person who might have been able to solve the situation. You said you don’t see any alternative, but what would you recommend if you were trying to set policies either for the IMF, the World Bank, or for the United States or for Russia vis-a-vis how to get out of that depression?

Dr. KRUGMAN: One of the virtues of not being a senior government official is not having to have answers for everything. I don’t actually know. I mean, it—I’m at something of a loss for what can work in Russia. The situation is clear enough. They dismantled a badly functioning centrally planned economy and failed to construct a working market economy, so they’ve ended up with the worst of both worlds. And they’ve ended up with a political morass. You know, we’ve learned, you know, property is theft, but when it’s that much theft that recently, it kind of discredits the whole system.

And so I don’t understand how to make it work. On the other hand, of course, we can’t wash our hands of it because there’s this little problem of the nuclear weapons. And I’m at kind of a loss. This is where I really say that, no, I would have to put in a lot of time trying to understand it. I’m not sure that I know what the answer is.

Mr. RATTNER: Let’s come back to New York and see if we have some more questions in New York. I’m sorry, Pete. Les Gelb said I wasn’t allowed to call on you, so we’ll go over here.

QUESTIONER: Related to Japan and the liquidity trap, are there—and whether or not that might happen in other places, are there unique things about the Japanese economy, the aging demographics, lack of inward migration and the lack of a Social Security system that make people particularly reluctant to spend in spite of stimulus in that country that might not be replicated in other places?

Dr. KRUGMAN: Every country’s unique, and the Japanese have some special characteristics. But the way I would describe Japan is that there are two stories you can tell about how they stumbled into this trap. One of them is largely demographic. It is the radical aging population, actual shrinking working age population, not essentially no immigration in their case, and that means a lot people saving for their retirement and it’s hard to get enough investment for all of that because how much investment can you have for a country where the workforce is expected to shrink 0.6 percent a year as far as the eye can see?

The other version of the Japanese story is a financial bubble that burst, and in bursting, plunged the economy into a kind of a low-level trap, this liquidity trap. My vote mostly is for the structural story, but if you actually take those two stories, what’s noticeable is that the first story sounds like Europe and the second story sounds like the United States. So it’s not hard—I think however you cut it, Japan is a very worrying omen for the rest of the Third World. Maybe not—it won’t play the same way. Maybe the way to put it is this: For Europe, yeah, the demographics are not quite as bad as they are for Japan, although they’re pretty impressive. Italy’s demographics look exactly like Japan’s, which is—someone should tell the pope.

But anyway, the—but the point is if Europe should slump, do you really think that cutting interest rates, cutting the call money rate the extra 2.5 percent that’s still left, would be enough to pull it out? So Europe is dangerously close to a liquidity trap. And if the U.S. stock market were to fall back to where it was the day before Alan Greenspan made his irrational exuberance speech, do you really think that getting the Fed funds rate down to zero would be enough? So I think that, yes, Japan’s unique, and with luck, no one else will experience the same thing, but it’s not something you want to count on.

QUESTIONER: But if you were a policymaker in either of those two places, recognizing this risk, which seems perfectly logical, what would you do now to prepare so it doesn’t happen?

Dr. KRUGMAN: For Europe, I think the answer is clear. Cut rates further now. There’s lots of slack in the European economy. There’s no reason why they shouldn’t be trying to pump that economy up. And I would say cut rates another half percentage point and maybe more than that just to get a really convincing recovery under way, and longer term, set a target inflation rate, which is not zero. I’d like to see—I would love to see—it’s never going to happen—I’d like to see the euro zone have the same guidelines that the British have, 2.5 percent inflation; not less than 2.5 percent inflation but 2.5 percent inflation.

The United States is a lot harder. I don’t think there’s much you can do now in a precautionary sense. I would just say if the bad thing happens, cut the rates quickly; you know, not dribs and drabs but quickly, like a pedal to the floor, like 1987. Other questions?

QUESTIONER: Depression economics, you know, it’s a really interesting subject, but one of the preludes to depression economics back in the 1920s was this asset bubble that was experienced—asset bubble in the stocks, real estate and so on. How do you feel about that now? Are we in the same situation? Are we looking at an asset bubble that’s about to burst or can this scene continue on?

Dr. KRUGMAN: Well, I’m one of those people who did the numbers and concluded that stock values were very hard to justify two years ago, so what do I do? Yeah. And, you know, it’s—and there’s been a lot of, at least to me, unexpected good news about the economy but not enough to justify the run-up since then. It’s really hard. You really see just how hard it is to take the long view here, and let’s put it this way. If you were to ask, “Is there a one-in-three chance that this really is a sort of 1929 or Japan-1989 type bubble?,” the answer is, yeah, that’s not bad odds.

By the way, it’s not totally clear that it really was a bubble in the 1920s. You know, if there had been no Great Depression, there might have been—those prices might have been justified. I don’t—you know, there’s a question as an investor, what do you do? And the answer is, well, if you’d taken my advice, you would have missed out on a lot of money so far, so I don’t know what to tell you. But the main thing is to be alert for policies, to be alert to the possibility that this is, indeed, a bubble.

QUESTIONER: Do you think Greenspan should raise rates at this point?

Dr. KRUGMAN: I don’t think that history justifies that. I mean, if you had a—if it were the kind of bubble that was leading to a lot construction, a physical excess capacity, if there was a wild real estate boom that was leading to lots of, you know, office space that will never be used, so that waiting would make it that much harder to stimulate the economy, if that becomes necessary, then you’d say, “Well, that would be a good reason to pop the bubble.” But so far, it’s paper gains, and I don’t think there’s a clear intellectual case for raising rates to pop the bubble, if it is a bubble. We just wait and see. It’s worth noticing, by the way, that both in 1929 in the United States and 1989 in Japan, the Central Bank did raise rates to pop the bubble and then couldn’t control the deflation when it came.

Mr. RATTNER: I don’t know. In the back?

QUESTIONER: From what you say, I was wondering how you would apply it to this general theorem that some have proposed that we need not have anymore basic depressions or any serious depressions, that the economist skills and knowledge and models are sufficient perhaps if advice is followed, if there’s flexibility in government to prevent that from happening, as against other people who say, “Well, when the next recession comes,” then, of course, we have to be prepared for it. I mean, where do you place your own profession?

Dr. KRUGMAN: Like the bumper stickers don’t quite say, “Stuff happens.” Whatever you’ve gotten yourself ready to deal with, something else will come along. Look, what we just had was the—this Asia crisis, even if we have now bottomed out, was the worst plain business cycle crisis that we’ve seen since the 1930s. You know, there were severe oil shocks in the 1970s that led to global slowdowns, but this was the worst, just plain demand collapse that we’ve seen. Japan has shown us that 1930s style liquidity traps are still alive possibly in the modern world.

If anything, I would guess that that—the world is probably more vulnerable to instability in the 20 years looking forward than in the 20 years behind us, because we have evolved around the defenses that we used to have that may have made us inefficient but also made us stable. I just don’t buy these—I’ve been in this business a long time. You know, I started doing economics more or less professionally in the mid-1970s, and I’ve seen so many crises come and, you know, it’s like “Jaws 3” or whatever where it’s not longer a question of what was going to happen or even when it was going to happen, but just from which direction. And that’s—and it—so I think that if people talk about the end of the business cycle are just silly.

Mr. RATTNER: Do you have another question out in LA?

QUESTIONER: Sure. Thanks. There’s much talk, of course, about the so-called restructuring of the financial architecture, and I think most people would agree that one of the basic problems throughout this recent crisis was bad supervision and regulation of financial matters in many countries. My question is this. You touched on this toward the end—a few minutes ago. How has it improved? I worry that unless significant improvements are made in regulatory abilities—and I do believe there has to be some regulation with a small arm—much better supervision. Would this be a good function for the Fed, another invisible export force to train Central Bank supervision, certainly the IMF? That’s not their expertise. The BIS is not their expertise...

Dr. KRUGMAN: ...supervision. But the—no, look, I guess I just don’t believe that that’s critical in any case. Of course, you do what you can, but I don’t think that a lot of investors were grossly misinformed about the economic situation in Southeast Asia. I think the facts were there on the table. It’s that people didn’t choose to believe in the risks that were there. And I also think that what looks now like extremely irresponsible lending, extremely irresponsible investment and so on is—some it was at the time, but a lot of it looks irresponsible, looks out of control given what happened.

I’ll give you the basic statistic. If you take the—if a reversal of capital flows were to force the United States to make the kind of trade adjustments that the crisis countries had in Asia, that would be as if the United States was forced to move from its current trade deficit to a trillion-dollar trade surplus by the middle of 2001. How many currently good loans would look bad in the United States if that happened? How many currently sound investments would look extremely foolish in retrospect? So I don’t think—the supervision end of the financial architecture reform seems to me to be almost ineffectual. That’s a motherhood issue and it’s not going to make much difference, and as far as I can make out, the rest of it has basically just evaporated.

Mr. RATTNER: Another question in New York.

QUESTIONER: Paul, it seems to me that there is kind of an odd tension in our view of the U.S. economy. You clearly think that there is some kind of an asset bubble. You said you thought that stock prices couldn’t have been justified two years ago, which is, you know—What is it? —30 percent or something like that.

Dr. KRUGMAN: Yeah.

QUESTIONER: Obviously, there’s concomitant corollary asset bubbles as a result of that. And yet, you say, well, the policy mix is perfect. Don’t do anything. Wait for the fall. Now I don’t understand quite if you really believe that the U.S. economy is on the—at least has some chance of being on the precipice of some kind of a deflationary cycle or just a crash, which could have a certain kind of vicious cycle...

Dr. KRUGMAN: Right.

QUESTIONER: ...because consumer spending is propping it up. Surely, there must be something the United States should do. And related to that is are you—is part of what you’re saying that you have been so surprised by good news on several fronts—rises in labor productivity, which I know does not explain asset inflation, but also technological revolutions—you know, AOL, Internet, and all that kind of thing—that somehow, you just want to wait and watch or what is the argument here?

Dr. KRUGMAN: Two things. One is—three things. One is I’m tired of looking silly. And even though in the long run, I may be right in the long run, we’re all dead and, hey, what can you do? Second is that there—it’s not—well, I’m not sure what the number of things here—but it’s not clear that monetary or fiscal policy is an appropriate tool for popping asset market bubbles. It’s not clear that there’s anything much you can do about asset market bubbles, except try to have a financial system that is robust enough that if one does pop, it isn’t the end of the world.

I just don’t think that there’s a strong case either in the logic or in history for taking an economy which doesn’t have inflation breaking out on the good side and raising interest rates simply because you think stock prices are out of line. For—you know, it doesn’t have a good track record. As it turns out, all of the great burst bubbles were actually burst by deliberate action by the Central Bank. Now this may be the—presumably, it would have happened anyway, but it certainly didn’t do them any good.

Mr. RATTNER: Yes, sir.

QUESTIONER: I wonder if you could say something about your assessment of China’s economic future? It’s sort of interesting that China hasn’t been mentioned so far, and how it fits into both Asia and the world picture?

Dr. KRUGMAN: OK. China, first of all, is the demonstration, I think, certainly that we pushed liberalization of capital accounts much too fast in the emerging world, not because China is a paragon but because it is—because China is, by almost any measure, any of the things that we now say where the sources of the Asian crisis is worse, all right. All right. If it’s crony capitalism, if it’s nepotism, if it’s unsound banking, you know, basically, China makes Indonesia look like Switzerland. And the only reason why China wasn’t caught up in the crisis full-scale was that, thank God, it had an inconvertible capital account. Now that, of course, enables them to continue with the sins, but it also gives them time to cope with them.

China’s economic problems are—they’re quite—it is having a lot of trouble, and it’s not having trouble for the reasons that the other Asian economies did. It’s having trouble because despite substantial trade surpluses, despite not being caught up with capital flight, it’s—bizarrely, for a poor country, it’s showing signs of a Japanese syndrome of high private savings and having difficulty maintaining enough investment to make use of those savings. I think score one for the demography theory because you could say that China is getting an unanticipated consequence of the one-child policy. And they’ve got to do something, and the current situation is not sustainable. I think there will be, one, devaluation, not this year but soon and for the rest of your life.

And there’s clearly pressures on them. It’s—I have to say that I’m planning to make my first actual trip to China, as opposed to Hong Kong, in September, and I’m planning to spend at least part of the summer boning up and trying to figure out what I really think. So I’m not an expert here. I’m a dabbler in China hoping to become at least reasonably well-informed by the end of the summer.

Mr. RATTNER: We’ll stay tuned. Why don’t we take one more quick question from LA, if there is one, and one from New York, and then we’ll wrap up. Do you have one more there?

QUESTIONER: Yeah. I just want to ask how do you look at the political leadership especially among the major countries that we’ve talked about, how do you rate them in terms of handling of the economy, especially Japan, China, and perhaps some of the Southeast Asian countries? How would you rate them? Do they have the political leaderships to sort of bring the economies around?

Dr. KRUGMAN: It’s been tremendously uneven. Japan—I think the Japan—actually, let me say that Japan’s political leadership, I think, has been quite forceful; unfortunately, often forceful in the wrong direction; that if you were to say, “Now what was the problem with Hashimoto?” It wasn’t lack of will. It was his determination to do exactly the wrong thing. And the current government is actually—if you—by measure, by the sheer scale of the fiscal stimulus, you know, that’s quite impressive. It’s—I think it’s a dead end policy, but, you know, given that they’re often intellectually on the wrong foot, they’re being quite determined about pursuing it.

The rest—the Chinese have certainly acted forcefully and, in the short term, effectively at containing the crisis. We’ve got to give them some credit for that. Well, the rest—it’s usually variable. I guess I don’t think that—clearly, weak governments and unstable governments are a terrible thing, but strong governments are not a panacea. You need strong governments, but you also need good ideas, and I think that’s the biggest problem that we now have.

Mr. RATTNER: I saved the last question for you. It’s not about Social Security, is it?

Dr. KRUGMAN: Let’s see, I found myself in—having dinner with Larry Summers and various other people a couple weeks ago, and I was afraid of another grilling from Larry about—he can give you a hard time. But fortunately, there were about nine people who wanted to argue Social Security with him, so I was perfectly safe.

QUESTIONER: I hope you haven’t taken a terminal risk to your membership by asking me a question. Paul, with a combination of hindsight, maybe in poor sight and insight, I wonder if you could look at the Asian situation from where we are today and say what should have been done differently, who should have done it differently. You know, in other words, what lessons do we learn, whether at the international level or at the local level, that stick out in your mind so we might be able to ameliorate or prevent a future crisis?

Dr. KRUGMAN: Wow. That’s—how many hours? No. Let me see if I can say some of them. The first lesson, it seems to me, is don’t get there in the first place. When the markets start to love countries and start to pour in lots of money, short-term money, that’s the time to try and stop it and try to limit it. If people had—if all of us had in early 1996 or, better yet, mid-1995, said, you know, Asia hasn’t been caught up in the tequila crisis, but these short-term capital inflows are creating the pre-conditions for an Asian version of it, then all of this could have been avoided.

Second lesson is probably when a crisis hits, try—don’t just try to win confidence but actually sit down at the most—the major sources of capital flight and try to stop it through—at least through direct suasion, if not necessarily regulation. That’s what the Koreans did more effectively than the rest, and that’s a large part of their key.

Third I would say is don’t get caught up in irrelevant objectives during the middle of a crisis. You know, in Indonesia, above all, you know, it was a rotten government and with a lot of rotten policies. But the IMF tried to remake a society as part of containing a financial crisis, and the fact is nobody’s good enough to do that, and I think it made the crisis much worse than it needed to be. Beyond that, the other thing is if somebody offers to supply money during a crisis, as the Japanese did, don’t try to think about what that might do to your strategic position 10 years later. Take it. But I think what we really need is to try as far as possible to just take advantage of the good times to avoid creating vulnerabilities for the next one, because there will be a next one.

QUESTIONER: Would you have favored Chilean type...


QUESTIONER: ...short-term controls?

Dr. KRUGMAN: Yeah. Oh, if—look, if—particularly now that we know that—let me say where I was wrong. I was wrong in believing that—I think I said this before—that there was a huge pool of potential flight capital. There will be eventually some day, but in most of the countries involved, there wasn’t. In Brazil, if you look at the actual capital flight that they experienced in their crisis, it was—although, in principle, there were hundreds of billions of dollars that could—it was all bank and credit lines. And if they had had measures to discourage short-term borrowing, then those short-term bank credit lines wouldn’t have been there to be pulled. And I think if there’s a very strong case that none of this would have happened if something like Chilean controls had been in place. Chilean style controls were very live on the agenda two months ago. As far as I can make out, they just faded out. And that may turn out to—we may have found our way out of this crisis too soon. I think that’s a great misfortune.

Mr. RATTNER: Well, that was a great question to end on. Thank you all very much for coming. Thank you, Paul, for a terrific presentation.

Dr. KRUGMAN: Thanks.

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