In Sunday's NY TIMES, Paul Krugman's op-ed says: >... will the turmoil in the stock markets spill over, not just into jewelry, but into the real economy generally? Is this the end of the "Goldilocks economy"? < PK doesn't really define the "Goldilocks economy": it's an era of low unemployment and low inflation, despite all expectations. >It's happened before. Never mind 1929 -- that stock slump occurred in an environment of institutional weakness and sheer policy stupidity that I think (I hope) no longer exists. We aren't going to raise interest rates to peg the dollar to gold, or allow banks to tumble like dominoes. The example to worry about is Japan in the 90's -- an economic juggernaut that stumbled badly after the burst of a financial bubble, and even a decade later has by no means regained its former vigor. < One problem is that the nature of the world changes over time, so that knowledge about what to do about a 1929-style crash doesn't automatically help the Fed deal with a 2000-style crash. As the economy changes, new types of stupidity arise -- or new meanings for the word "stupidity." In many cases, "stupidity" is defined only after the fact. >And indeed, some Japanese have been arguing for years that any day now the United States is going to go through the same comeuppance they experienced -- that our "new economy" is as fragile, perhaps illusory, as their bubble economy of the late 1980's. And after the last week a few Americans may be wondering if they have a point. >But I've been obsessed with Japan's economic problems for years -- it really bothered me to see a wealthy, politically stable country seemingly unable to pull itself out of a simple demand-side slump. I think I have some idea why in their case what started as a mere paper loss ramified into something much worse. And to me America's prospects of avoiding a similar fate look very good. < It's always a mistake to put too much weight on historical analogies. Below, PK argues that the US ain't Japan. Of course! It also ain't 1929. He doesn't seem to pay any attention to the logic of how a capitalist economy produces crises of the Japan or 1929 sort. This is not surprising, since his basic theory -- neoclassical theory -- blames exogenous shocks and government bumbling for all bad things. >Broadly speaking, there are three ways that a stock slump can turn into a prolonged recession [assuming, it seems that the Japan analogy works]. First, a decline in stock prices can expose an underlying lack of good projects for businesses to invest in. Second, falling prices of assets can undermine corporate balance sheets, leaving companies unable to make investments no matter how justified. Third, a financial slump can inspire perverse government actions -- like raising interest rates to defend your exchange rate even as the real economy implodes. < It's interesting that PK ignores the impact of a crash (a real one, as opposed to the partial one that happened last Friday) on _consumer_ balance sheets. Given the steep rise of consumer indebtedness -- including margin borrowing -- this seems quite relevant. Also, there's an expectations effect on both business and consumers. Finally, it's interesting that PK ignores such government blunders as raising taxes to try to balance the budget (as falling GDP reduced tax revenues), which made the 1930-33 recession worse. He also ignores the fact that until it was too late, the Fed _wanted_ a recession back then, because it would "liquidate" the imbalances in the economy (high wages, inefficient farmers, etc.) >On the first count: America is in the midst of a technological revolution -- unlike Japan, which in 1990 was at the end, not the beginning, of a productivity surge. And demography is on our side: a steadily growing work force, thanks in part to immigration, should help to sustain continuing high investment. < Gee, it could be argued that in 1929, the US was at the beginning of a technical revolution. And who's to say that Japan was at the end of its technological revolution? Not only is a lot of Japanese manufacturing doing well [calling Dennis Redmond!], but is it not possible that the Japanese stagnation helped delay the _implementation_ of the "technological revolution" there, so that it only _looks_ like it's ended? In the 1930s in the US, there was quite a lot of technical progress (most labor productivity studies see a steady upward trend between about 1919 and 1970 or so at rates not seen before or since) but the implementation of the technology was delayed, since demand was low. I've always been doubtful of demographic arguments in macroeconomics, but I'll leave that element of the conventional wisdom for another day. High productivity growth sustains [real] investment only if wages rise in step with productivity (or if net exports or the government fill the gap) so that consumer demand can increase. Investment is "relatively autonomous" from personal consumption (unlike the view of many underconsumption theories), but to the extent that it gets out of line with consumption growth, it increases the instability of the private sector. If investment falls and consumption can't rise to fill the gap, corporate profitability falls as a result of the realization crisis. Though high productivity growth relative to wages helps profitability in production, this process can go too far (as in the late 1920s) so that realization problems kick in. It's true that consumption has been increasing smartly (so that the instability of investment is less important), but that growth has been accompanied by an increased degree of consumer indebtedness. (This rise is partly due to the failure of real wages to rise in step with productivity. It's not just a matter of rich people treating paper gains on the stock market as real assets.) That means that consumer spending is increasingly unstable, likely to fall sharply (dumbly?) due to a stock-market crash or one of the inevitable shocks that capitalism throws up. >On the second count, things could be much worse. There has been some increase in corporate debt in recent years -- and some individuals have, of course, gotten overextended. But we don't need yet more dot-coms to keep the economy going, and by and large the prospect that companies other than dot-coms will find themselves unable to pursue profitable investment projects because they are unable to raise the cash seems remote. < The problem is that the fall of the value of "dot-com" assets can easily be associated with the fall of non-dot-com assets' value. This contagion is one characteristic of a true crash. >On the final count: Sometimes it's good to be big. The United States has a huge economy, which despite growing international trade is not all that dependent on imports. So even if the new nervousness on Wall Street drives down the value of the dollar -- certainly a possibility --- the Federal Reserve won't feel that it has to raise interest rates to prop up our currency.< If the dollar does fall steeply, that would cause an inflationary shock: imports -- including imported raw materials (except oil) -- would suddenly become more expensive. At the same time, the international competitive pressure on exporters and import-competing firms would be weakened, allowing them to raise prices. Such an inflationary shock would encourage the Fed to raise interest rates. (Remember that Greenspan sees inflation the way Ahab saw Moby Dick. Remember also that PK and others have been encouraging Japan to allow inflation as a way of spurring recovery, but that the Japanese Central Bank has not complied. The fear of inflation rules central bankers (and their main constituency, the bankers).) This would encourage recession, as would establishmentarian unhappiness with recent rises in real wages. One further problem is that, as in 1929, the US is one of the few truly bright spots on the world economic map, propping up the rest of the world. So even a slowdown of the US -- or a depreciation of the dollar -- would undermine the efforts of many other countries to recover from the slumps they've been in. This would encourage a fall in US exports, which would make the the red ink on the US balance on the current account even darker and encourage a steeper recession. The US could join the world process of competitive austerity and export-promotion, pursuing the "race to the bottom" with a vengeance. As the accelerator theory of real investment points out, even a slowdown of the US economy can cause a steep fall in private investment. This was one part of the most recent recession in the US and made the Fed's efforts to revive the economy much weaker. >Nor need we fear, the way smaller Asian countries did in 1997-98, that we will be crushed by the burden of foreign-currency debts: we do have debts to foreigners, but relative to the size of our economy they aren't that large -- and anyway (shhh! don't tell anyone) they're in dollars.... < US debts are in dollars, but the Fed knows that the US can't abuse the privileges of seigneurage too much. (And what if OPEC decides to stop stating oil prices in dollars?) In the short run, it might encourage a speculative flight from the dollar, which would encourage the negative effects sketched above. I can't predict the future, but I still think that the longer the US economy avoids a recession (without changing to wage-led growth), the more that imbalances will accumulate, and the worse the collapse will be (whenever it happens). Jim Devine [EMAIL PROTECTED] & http://liberalarts.lmu.edu/~jdevine
