A decade ago, this year’s Nobel laureate in economics, Paul Krugman, wrote a little book entitled The Return of Depression Economics. It sank like a stone.
The East Asian financial crisis of 1997-1998 was sharp but short and quickly cured once the IMF realized that feckless governments were not the problem and US Treasury secretary Robert Rubin parachuted the New York banks into South Korea’s economy. The collapse, not long after, of the dot-com bubble in 2000-2001 brought on not a depression but merely an output decline so mild as to barely warrant the name “recession.”
Now Krugman is back with a revised and expanded version of his book, and, sadly, the timing is perfect. For there is a much better case to be made today than there was in 1998 that we should be thinking in terms of “depression economics.”
But the book does not tell us what “depression economics” is supposed to replace. So let me try my hand at defining non-depression economics:
Short-run economic policy should be left in the hands of the central bank, with the legislature and the executive focusing on the long run and keeping their noses out of year-to-year fluctuations in employment and prices.
Central banks’ highest priority should be to maintain their credibility as guardians of price stability, and only then turn their attention to keeping the economy near full employment, which they should do by influencing asset prices — upward when unemployment threatens to rise, and downward when an inflationary spiral looms.
Central banks should influence asset prices through normal open-market operations — by buying and selling short-term government securities for cash, thus changing the “safe” interest rate and the price of longer-duration assets.
While the central bank should stand ready to intervene to prevent bank runs, it should let the financial sector run itself with a light regulatory hand, viewing itself not as a chaperone but rather as the designated driver in the case of speculative excess.
This is the doctrine that Krugman argues is no longer sufficient for our age. And he has a very good case. Nearly all of these principles are, today at least, honored more in the breach than in the observance.
Today, short-run economic policy cannot just be left to the central bank alone. For one thing, its balance sheet is not big enough. At a minimum, the central bank now needs the assistance of that part of the government that taxes and borrows.
Moreover, the highest priority for central banks can no longer be to maintain their credibility as guardians of price stability, but rather their credibility as guardians of the financial system’s stability and soundness. Once that highest goal has been achieved, central banks can turn their attention to trying to keep the economy near full employment.
One principle does remain true: central banks should try to keep the economy at near full employment by pushing asset prices up when unemployment threatens to rise. But central banks today are influencing asset prices through a very large number of channels and procedures other than conventional open-market operations: they are trying to affect not just duration discounts but risk, default, and information-driven discounts as well.
Nor is it any longer accepted that such actions will be sufficient. Fiscal stimulus is needed as well. Non-depression economics eschews fiscal policy, on the grounds that central banks’ tools are powerful enough and their decision-making more effective and technocratic than that by legislatures. But in today’s prevailing conditions, we cannot afford this perspective.
Finally, central banks still stand ready to intervene to prevent bank runs. But the presumption in favor of light financial-sector regulation now has few defenders. The consensus view is rather that of William McChesney Martin, who served as US Federal Reserve chairman from 1951 to 1970: A good central bank prevents speculative excess by “taking away the punchbowl before the party really gets going.”
J. Bradford DeLong is professor of economics at the University of California at Berkeley and a former assistant US Treasury secretary.
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