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The Return of Depression Economics

Paul R. Krugman

posted on 01 November 1999

reviewed by Joe McCauley

book is interesting, worth reading, in part because of it’s
attempt to avoid moralizing and to find instead ‘mechanical’
reasons for economic slumps, and also for its presentation of facts
about sequences of events. The book is also short: the presentation
and arguments are concise and easy to follow. The mechanics
emphasized by Krugman are large (often leveraged) money transfers and
leveraged credit. The examples discussed are about Japan, Thailand,
Mexico, Russia, and Brazil. Money transfers via hedge funds are
nicely discussed.

seen from a western economist’s eyes, presents a problem
economy: stable currency and employment (no growth), and high savings
(people tend to keep their money in the bank). Krugman labels this
no-growth/high liquidity state a ‘liquidity trap’. He
describes a toy economy that provides a model of a liquidity trap,
the Washington DC Baby-sitters’ Co-op (see also Akerlof’s
‘Market for Lemons’, which came earlier). In the
baby-sitter’s co-op people start with small, equal amounts of
script and a state is reached where parents want baby-sitters
(demand) and other parents want to baby-sit (supply) but there is no
matching of demand to supply because the script supply (money supply)
is too small (savings are too high). Krugman’s proposed solution
to the liquidity trap is to inflate the script supply. That is also
his proposed solution for destabilizing Japan’s economy and
society: to make saving less desirable by inflating the money supply,
therefore inducing people to consume and speculate. The interesting
thing is that on Thursday, 14 October 1999, that is exactly what the
Bank of Japan agreed to do by announcing that they are buying back
bonds. So, we now have running an uncontrolled experiment of
Krugman’s proposal.

presents elsewhere a mathematical model of the liquidity trap (see
his web page), but it’s based on the mythology of a utility
function and anyway is only a static model with no dynamics and no
time scales. The baby-sitters’ co-op problem reads like the sort
of toy system that a theoretical physicist ought to be able to model
either dynamically or kinetically, but without making unnecessary
assumptions like path-independence of a utility functional. As for
Japan, one might ask: why label their society as a “problem”
because the economy and currency are stable, especially since people
save a lot and there is as yet no large-scale unemployment? The
reasons that they tend to save rather than speculate by buying stocks
and bonds are several-fold: (1) the mafioso nature of Japan’s
finance system, where people got burned very badly in the last bubble
(see Devil Take the Hindmost, by Edward Chancellor), (2) high
financial friction, or large brokerage fees (soon to be destroyed by
the introduction of discount brokerage houses into Japan as of 1
October 1999), and (3) the fact that Japan has no social security
system. If we ask why western politicians and economists persistently
label Japanese habits as ‘problematic’, the answer could
well be an unquestioning, bordering-on-dogmatic belief in the
econo-religion of growth and progress by the accusers. French farmers
rebelled with very good reason against European Union demands for

Drucker pointed out in 1983 in The Frontiers of Management
that trade in goods and services no longer determines exchange rates,
that money transfers/month across international borders are many
times the value of exports/imports. This fact, that the size of money
transfers dominates everything, plays a key role in Krugman’s
analysis. He replays for the reader the tape from (Thailand, 1997
and) Brazil (fall, 1998) where, with still non-increasing prices, but
at the onset of an economic slump, Brazil’s currency came under
pressure due to fallout from the collapse of Russia. Brazil tried to
devalue slightly and the currency was routed (via hedge funds).
Krugman poses the general question why, when a currency (like the
Baht or Real) is weak, and the government (either credit-leveraged
Thailand or unleveraged-Brazil) tries to devalue slightly, the
devaluation tends to turn into a run on the currency. The answer, he
asserts, is that this happens because people believe that it will
happen, and this belief then makes it happen (via hedge funds). In
other words, a self-fulfilling expectation is created. This rings
true because it reminds me of Feynman’s observation (in
Surely You’re Joking, Mr. Feynman
) that socio-economic
phenomena are not like physics or mathematical laws of nature. In the
latter belief doesn’t count (you can’t make it rain by
wishing, and a billiard ball can’t think and change its path),
whereas in the social arena you can act on beliefs and then cause
things to happen. We should not forget this fact while we have our
fun in taking up the challenge to try to improve on Krugman’s
modeling of the baby-sitters’ coop, or econometrics and finance
in general. Here, my (former-editor) wife, who reviewed the first
draft of this review, said that I should be more explicit about how
to improve on the babysitter co-op modeling, but (a) either I don’t
know how yet, or (b), I’m not saying. At any rate, it’s all
still an open problem.

in comparison with Krugman’s book The Self-Organizing
, where he seems only to parrot ideas that he didn’t
invent and doesn’t understand (I got this impression in the
early pages and so did not read further), I found The Return of
Depression Economics
to be both enjoyable and informative.

a quasi-economist I end by making the following prediction, which I
will stand on: markets in Europe (particularly Germany) will boom if
and only if two conditions are first met: (1) pension funds must go
into the market (where else should the money come from?), and (2)
telephone rates ]must be cut to flat-rates, American-style (how else
can anyone pay the telephone bill for internet use?). Presently,
financial friction (telephone and brokerage costs) is simply too
high, particularly in Germany. That’s my advice to Gerhard and
the EU (other than to stop messing around with the farmers).

Joe McCauley

Professorof Physics

University of houston

Houston, Texas 77204

See another review on the same book (by the economist J. Bradford DeLong)


G. A. Ackerlof, An Economic Theorist’s Book of Tales,
Cambridge (1973), and thanks to Y.C. Zhang for suggesting this
reference to me.

P.R. Krugman, The World’s Smallest Macroeconomic Model,

E. Chancellor, Devil Take the Hindmost: A History of Financial
, Farrer Straus, Giroux (1999).

Drucker, The Frontiers of Management, Penguin (1983).

R. Leighton, R.P. Feynman, A. Hibbs, Surely You’re Joking,
Mr. Feynman
, Norton (1997).