The perils of global finance

Ulhas Joglekar ulhasj at
Sat Aug 12 21:05:56 MDT 2000

Volume 17 - Issue 16, August 5 - 18, 2000
India's National Magazine on
from the publishers of THE HINDU

The perils of global finance

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 that 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
second 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 America. 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" economies. 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 the 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 specialise 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 out 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 the 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 argue
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 policy, 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 however
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
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 demand 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 contain
the growing fiscal deficit. And, sure enough, the economy plunged into
recession. Soon the recession was passed on to other Asian economies as
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 and 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
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 crises 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 flight (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 experiencing
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 invest
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 neconomy 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 regimes (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 deeper
level of analysis is necessary to understand the frequent crises of
capitalism, including their recent manifestations.

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