Krugman, Keynes and Hoover

Reading Krugman's book, one of the most striking things to me was how much it brought up all the old issues I had learned in basic economics. In international trade, for instance, the issue of fixed versus floating exchange rates. Fixed exchange rates have the advantage of making international trade easier and more predictable. Floating rates cause wild fluctuations with great inconvenience to anyone engaged in international trade. But fixed exchange rates undermine a country's ability to set its own economic policy and require it to prioritize maintaining its exchange rate over the health of its domestic economy. A third alternative is trade and capital restrictions, but these introduce distortions and onerous regulations. So, Krugman says, if we can't have fixed exchange rates, freedom to set domestic economic policy, and international free trade, which of the three are we willing to sacrifice. In college I read books from the 1950's to the 1970's making exactly the same point.

And then there is the matter of the IMF. The Keynesian/monetarist approach to a economic downturn is to lower interest rates, run a deficit, and let the currency fall. The IMF, Krugman complains, demands exactly the opposite, that a country facing a crisis raise interest rates, balance the budget, and maintain its exchange rate whatever the domestic cost. And my response to all that is, so what's new? That is what the IMF has always done, so far back as I can remember. The IMF has always regarded domestic consumption as a waste of resources that should be reserved for important people like foreign creditors and investors. In theory, if an economy were to cut domestic consumption to zero, export its entire GDP, and hand its entire export income over to foreign creditors, the IMF would probably regard its economic management as ideal. Even the IMF realizes that this is not altogether realistic, but it does expect a country to cut domestic consumption as much as possible, export as much of what it produces as possible, and divert as much as possible of its export revenue to foreign creditors. And to be willing to sacrifice its domestic population (especially those worthless poor people who don't produce any foreign exchange and can't cause capital flight) to the wishes of international investors. Why does Krugman treat any of this in the 1990's at anything new?

And yet, although I am inclined to share Krugmans's outrage, a disturbing thought lurks at the back of my mind. What if the IMF, after all, is right? There is some evidence in their favor. As Krugman acknowledges, Mexico and Argentina followed IMF orthodoxy and experienced a short, sharp drop, followed by a rapid recovery. Japan, by contrast, followed Keynesian/monetarist orthodoxy and experienced a "lost decade." So what if retrenching and getting it over with fast is, after all, the better policy?

There are counter-arguments, of course. A small, open economy like (say) Thailand depends on foreign investment and exports for its success. A large economy like (say) Japan or the US relies mostly on domestic investment and produces mostly for domestic consumption. Sacrificing domestic consumption to please foreign investors may therefore make more sense in a country that produces most for export than one the produces mostly for itself. Krugman describes in detail how Britain and Australia were able to devalue their currency without suffering any harm, while devaluation by Thailand or Mexico set off a panic.

That debate is becoming more and more current now. Although both the US and Europe initially responded to the economic crisis with Keynesian stimulus, Europe is now embracing austerity, while the US will almost certainly run deficits into the indefinite future. So on one hand, we should have a simple test. If Europe's economy crashes and bounces back, while the US sinks into a Japanese-style lost decade, we will know that the IMF/Hoover approach is right and it is time to start balancing the budget, no matter how painful. By contrast, if the US does better than Europe, we can chalk it up as a victor to Keynes.

Or can we? The Republicans are blocking any further stimulus and calling for spending cuts, but it seems unlikely that they will make any but the tiniest token cuts in spending any time soon. Assuming they take over Congress in 2010, they may even show themselves to be good Keynesians by enacting another tax cut. All this means we can expect huge federal deficits as far as the eye can see. But states do not have the option of running deficits. Barring major federal assistance (which Republicans and Blue Dogs will almost certainly block), states will be making deep cuts next year. The US, too, will be embracing austerity, just not at the federal level.

It's a dilemma. On the one hand, I would really like Keynes to be right, not just as a matter of intellectual and ideological satisfaction, but because I really would rather not have to put an already traumatized economy through any more pain. On the other hand, since austerity is heading our way whether we like it or not, I would really like for it to work.