Economics columnist warns of the return of 'the ghosts of the 1930s'

Until about five years ago, Princeton Professor Paul Krugman believed that the Great Depression of the 1930s could never repeat itself.

Now he's not so sure.

Pointing to the economic crises roiling Japan and Argentina, Krugman on March 18 and 19 discussed how "intractable slumps" and "currency crises" in those countries could manifest themselves more broadly, and with devastating results.

"The ghosts of the '30s are back in the modern world," he said.

Krugman, an economics professor and a New York Times columnist, spoke at the Tanner Lectures on Human Values, an annual program sponsored jointly by the President's Office and the Program in Ethics in Society.

Introducing the first lecture, President John Hennessy described how Krugman, an economist who founded the "new trade theory," a major rethinking of the theory of international trade, keeps his feet firmly planted in the real world. In 1976, he said, Krugman and some students from MIT experienced real-world economics when they assisted the Central Bank of Portugal as the country recovered from a revolution.

"What I learned from that experience was the power of very simple economic ideas and, simultaneously, the uselessness of theories that cannot be given operational content," Krugman wrote in a 1995 paper, "Incidents from My Career," that Hennessy quoted. "In particular, my experience in a country in which it was a major challenge even to decide whether output was rising or falling gave me a lasting allergy to models that tell you that a potentially useful policy exists without giving you any way to determine what that policy is."

In his first lecture, Krugman discussed Japan and the United States, pointing out that the countries share economic freedom, large economies and access to the same levels of knowledge. Nevertheless, Krugman said, Japan has been unable to pull itself out of a slump for more than 10 years. "If you look at the Japan situation, what I thought was a myth is occurring in Japan," he said.

Krugman explained that countries usually make monetary policy by lowering or raising interest rates to stimulate or cool down the economy. For example, he said, the U.S. Federal Reserve last year cut the overnight money lending rates between banks from 6.5 percent to 1.75 percent to stimulate an economy in recession. In Japan, however, the equivalent lending rate is essentially zero. If a rate is set at zero, Krugman said, cash starts to dominate as an asset -- creating a so-called "liquidity trap." Japan now is in a deflationary environment where prices are dropping 2 percent a year, he said.

"One way to get into a liquidity trap is to expect continuing deflation," he said. "It's scary that Japan has now arrived at that point. The Japanese are well set up for [the kind of] deflationary spiral that happened in the 1930s. That's an extremely grim prospect." In such a situation, conventional monetary policy is ineffective in stimulating economic activity. The Japanese have yet to find a way to reverse deflationary expectations.

Although Japan in the 1980s and the United States in the late 1990s both experienced stock market bubbles, Krugman said, important differences persist. U.S. land prices (except in places such as the Bay Area) did not reach the astronomical levels experienced in Japan during its boom. The countries also have very different demographics, with Japan facing a looming shortage of workers due to an aging population, a low birth rate and an unwillingness to accept immigration or allow Japanese women to participate fully in the workforce.

"That's depressing because it's hard to get people to invest when they know the economy is going to have a shrinking labor force," he said. "A loss of hope is a big problem."

The United States has avoided the liquidity trap in its recent recession, Krugman said, but it may have been a close call. The country has hit an economic bottom, but he is not sure whether it is the bottom. "We can't be guaranteed that it won't happen again, which means that the Depression-era problems are still with us," he said. "That's terribly frightening."

In his second lecture, Krugman said that although Japan's problems are severe, they are dwarfed by the crises faced by developing countries. Although Mexico and South Korea managed to emerge successfully from serious economic crises in the mid-to-late 1990s, Krugman said, other countries have not been so fortunate. Thailand has never fully recovered from its recession, Indonesia's economy is a "sheer disaster" and Argentina is in the throes of a crisis, he said.

Unlike the United States and Japan, which can exert more control over their monetary policies, smaller countries dependent on international trade have been plagued by currency devaluations in the last decade. "Why don't these countries have the freedom of action to fight slumps?" Krugman asked. Critics often are quick to "blame the victim," he explained, with people pointing to a country's "rotten economy, polity or society" to account for a crisis. While "crony capitalism" certainly damaged Asian banks, he said, it cannot explain all the problems Asia experienced.

Furthermore, Argentina holds important lessons for economic policy in many parts of the world, Krugman said. In 1910, Argentina looked as favorably disposed as any zone of European resettlement. "Why did a country that had the same prospects as Australia or Canada end up as a Third World country?" he asked. "There is no answer to that."

At this point, Krugman continued, it is not clear how Argentina's story will end. "It definitely is bad to be a small, less developed country that markets don't give the benefit of the doubt," he said. "We should be prepared, in the face of really bad [crises], to try unconventional policies. Countries that have played by the rules have suffered catastrophically. Some of the countries that broke [the] rules did better."

The Tanner lectures are held annually at Stanford, Harvard, Yale, Princeton, the universities of California, Michigan and Utah, and in England at Cambridge and Oxford universities. Established in 1978 by Obert Clark Tanner, an industrialist, legal scholar and philosopher, the lectures are meant to consider human values and the human condition.