SYNOPSIS: Defends inflation and Capital Controls as necessary outgrowths of responsible Economics
About five months ago I started saying crazy things. First I declared that Japan needs inflation; then that temporary capital controls may be the best of a bad set of options for emerging Asia, Brazil, and other countries faced with speculative attacks. These views have been controversial, to say the least; I guess the Wall Street Journal was being complimentary when it classified me, along with Jeffrey Sachs and Joseph Stiglitz, as a would-be "mini-Keynes", but many others have condemned my positions as impractical and irresponsible. Certainly they don't sound like the sort of thing one is used to hearing from respectable economists.
Why am I saying such things? Not because I have turned my back on careful economic analysis. On the contrary, I have recently become an economic heretic precisely because I do believe in the importance and usefulness of systematic economic thinking. What bothers me about the world economic situation right now is not only the severity of the punishment being meted out to many economies (and the people who live in them), but the casualness with which policymakers and pundits have accepted the loss of one of the key achievements of economics as a discipline: the taming of the business cycle.
In my view, economists have made two great contributions to human life. The first was the discovery by the classical economists of the invisible hand - that is, of the way in which a market economy converts the individual pursuit of self-interest into a force for social good. The long run progress of economies depends crucially on their willingness to allow markets to guide the allocation of resources, and economists have helped convince the world to let the invisible hand do its job.
But a society must survive to reach the long run. That is where the second great contribution of economics comes in: the discovery by John Maynard Keynes and his successors that the instability to which market economies can be prone is not an unalterable fact of life, that recessions and depressions can and should be fought.
I do not view a belief in the virtues of free markets and a sophisticated Keynesian-tinged view of macroeconomics as contradictory. On the contrary, to my mind they are complements: the ability to use monetary and fiscal policy to limit macroeconomic instability is crucial to the case for letting markets run free, both as a matter of welfare economics and as a matter of political realism.
Only a few years ago it seemed to me, as it did to most economists with an interest in policy, that the problem of stabilization had been largely solved. That was not to say that recessions were a thing of the past. Even in the United States, sometimes the Fed would get careless about inflation, then need to impose a recession to restore acceptable price stability, as in 1979-82; other times it would simply fumble the ball, and allow a basically unnecessary recession like that of 1990-1. But the tools to fight recessions were available and well-understood, and one could take it for granted that central banks and finance ministries would use them. This meant, in turn, that the important issues in economic policy involved the supply side rather than the demand side - that questions like how to accelerate productivity growth and reduce structural unemployment, not how to ensure adequate spending, were the hard problems.
But over the last few years all that has changed. Right now Japan, the world's second-largest economy, is slipping deeper into what is in effect an eight-year demand-side slump, with no end in sight. Emerging Asia has seen miracle turn to debacle, again at least in the first instance because of collapsing demand (the potential output of Indonesia didn't decline by 15 percent in a year). And Latin American nations are pursuing perverse macroeconomic policies as you read this: raising interest rates and cutting spending in the face of slowing growth or outright recession. So far the old rules still seem to apply for the United States and Western Europe; but for the rest of the world it is as if an ancient plague has suddenly reappeared, in a form resistant to modern antibiotics.
This seems to me to be a momentous setback, not only for the world economy, but for economics as a discipline. And I am really shocked that more of my colleagues don't see it that way, or share my sense of urgency about finding some new ways to fight the plague.
More specifically, two aspects of the discussion of the world financial mess dismay me.
First is the remarkable extent to which we have defined success down. Consider the Mexican experience of 1995. This is now widely regarded as a success story - indeed, I have myself labeled it as such. But remember that Mexico suffered an incredibly severe slump - a comparable slump in the United States would have produced double-digit unemployment - and only after several years was the economy back where a reasonable projection in 1994 would have placed it. This was a success only in the sense that catastrophe was avoided; if it seemed more at the time, it was because most of us thought that it was a one-time event, that the Mexican rescue had saved a system that would work well in the future. It turns out now, however, that the Mexican crisis was only the first of many; that emerging markets in general apparently now face a pattern of repeated crises.
Now suppose that each individual story ends well - that two years from now South Korea resumes decent growth, that Brazil does not suffer a collapse of the real and suffers only a moderate recession, and that the next crisis and the one after that are similarly handled. The IMF and Treasury will, with some justification, be proud of their crisis management; yet if you back up and look at the systemic performance, what you see is a picture of instability, of wasted resources and in many cases blighted lives, that is far worse than anyone could have imagined a couple of years ago.
Second, I am dismayed and a bit angry about the readiness of economists and the international community to rationalize failure, to invent on the fly new economic principles that explain why countries must suffer recessions that appear gratuitous in terms of the usual logic of macroeconomics. Japan, we are told, cannot have an economic recovery unless it carries out massive structural reform. Where did that come from? Structural reform is supposed to help the supply side of the economy, not be a precondition for increasing demand. Southeast Asia, we are told, cannot have a recovery unless it carries out a complex process of restructuring internal debt. Maybe, but that's a new principle - made even more dubious by the fact that the massive overhang of bad debt is at least as much a consequence as a cause of the region's slump. Brazil, we are informed, must suffer a recession because of its unresolved budget deficit. Huh? Since when does a budget deficit require a recession (which itself will, of course, make the deficit that much harder to bring down)?
I'm not saying that the world's demand-side problems can simply be made to disappear if we tell countries to reflate; there are some severe constraints operating given the current rules of the game. But we should at the very least engage in some agonized soul-searching over whether those rules are worth honoring if this is the kind of world they lead to.
Above all, we should be prepared to challenge conventional ideas about what is practical and responsible. Everyone knows that Malaysia's new strategy of credit expansion behind currency controls is irresponsible and impractical. The sound policy is a concerted effort to write down and restructure the debt overhang, with schemes like Indonesia's Jakarta Initiative, right? But the Jakarta Initiative is the successor to June's Frankfurt Initiative, announced with much fanfare, which found precisely zero takers: not a single company took advantage of the scheme. This is an extreme but not isolated example of the growing gap between the solemnity of the official rhetoric about strategies for recovery and the almost comic ineffectuality of those strategies in practice. If you look around at the efforts now being made to deal "responsibly" with the world's problems - Japan's bank reform scheme, which will chip away at the bank problem but do little if anything to increase demand; the attempts to clean up the debt overhang in Thailand and South Korea, which many people say privately are nowhere close to producing the kind of resolution that would get investment restarted; the rescue package for Brazil, which may save the real but will do nothing to prevent a nasty recession - the overwhelming sense you get is of a failure to match the size of the solution to that of the problem, of trying to bail out a sinking ship with teaspoons.
Just because the conventional wisdom is wrong doesn't mean that every alternative is right. You don't have to agree with me that inflation is the answer for Japan, or that currency controls, with all their flaws, are a better option for emerging markets than trying to satisfy short-term capital. But any open-minded economist, pundit, or policymaker should be willing to admit that conventional wisdom is working very badly, and that there is now a very good chance that some of today's outrageous heresies will turn out to be tomorrow's simple good sense.