Return of depression economics Essay

Return of depression economics

The central theme of the Return of Depression Economics as it seems is that good economies do face worse things. Krugman book is founded on the economic crisis that threatened the Asian and Latin America economies.  He tries to establish what the international policy makers are doing wrong arguing that the earlier economic crisis should be a warning for all. In this context, Paul embarks on showing how the US economy and that of the whole world is plunging into a great financial crisis as a result of failures in the regulations in regard to financial and monetary policies adopted. In his book, Paul lays out the steps that need to be taken in an effort of guiding the world economy away from deep recession. As stated earlier, his work is based on past economic disasters in the world and specifically the stagnant Japan economy and the financial crisis that swept the world economy in 1990s. He looks deep at the currency crisis the diffused from Britain, Sweden, Mexico and Argentina among other world economies.

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As argued by Paul, common international economic policy tools such as the cutting of interests rates by Federal Reserve cannot be used any longer to contain an economic depression. In any case, a depression in the economy would require adoption of new policy tools as opposed to the usual tools. Paul reviews the 1930s depression and argues that the economic policy tools used then are totally ineffective in containing the current economic crisis in the world especially in United States (Theodore, 1997, pp. 47).

As a result of the economic crisis, an upsurge in the unemployment rate will result in a decline in consumer spending thus a further decline in the level of investment. This will create a vicious cycle in that less expenditure by the consumers and decline in investments will result further increase in unemployment. As argued by Paul, the result is that there will be a contraction in the economy one that resembles that of 1930s. In an effort to save the situation, the US government will have to increase her spending level and financial aid to those affected by the crisis.

Krugman in arguing his points analysis the reasons and factors that led to the stagnation of Japans economy. In this context, he analyzes how a decrease in consumer and investment expenditure as a result of the collapse of 1980s financial bubble led to a big economic crisis in the country. As a result of the crisis, assets owned by banks and other financial institutions became worthless compared to the debt they had borrowed to invest in these assets. Paul however does not give a specific answer as to what can be done in containing a decrease in aggregate demand. On the other hand, he suggests various tools and strategies that can be applied in such a case. According to him, the central bank should reduce the rate of interest close to zero percent in an effort to enable people borrow money cheaply.

Still, he argues that the government should operate a budget deficit or run deficit spending in an effort to contain a depression. As Paul argues, the root problem in economic crisis is lack of enough demand in the private sector. To solve this as suggested by Krugman, the governments when faced with an economic crisis should intervene with monetary expansion policy tools, monetizing enough debt that would see to it that interest rates are driven down such that borrowers can borrow from financial institutions as a cheaper rate. Monetary expansion policies can then be combined with programs of deficit spending in an effort to employ resources that are productive and which cannot be employed in any other way. To Krugman, the application of such policies and in accordance to rules laid by Keynes, economic recessions and other economic crisis can be mitigated to a large extent even though they cannot be totally avoided (Paul, 2008, pp.67).

Moreover, Krugman argues policy makers can also try to engineer inflation in the economy but at moderate levels to reverse a depressed demand. Finally, he argues that the government and those concerned with policy makings can adopt campaign strategy in an effort to change the perception of the population about investments in corporations being risky. In this context and as argued by Krugman, the government should make investments through cash hoarding look risky too to the people. Essentially, they can change their minds and increase investment spending especially in corporations. He goes a step further to argue that since the lowering of interests rates has not yielded enough in Japan economy, the next step that should or need to be taken is generate or engineer a moderate inflation in an effort to pull the economy from a liquidity trap. Analyzing this, one can deduce that Krugman when suggesting the creation of a moderate inflation does not have all answers. On the other hand, he seems unconscious of the problems associated with such inflation. For example, though inflation can boost the aggregate demand, it can cause a serious and dangerous shift in supply. Firms Employees would demand a higher pay thus increasing the costs of operations and by extension diminishing employment levels and real production that would be generated by the aggregated demand. In such a case, it would be possible for costs in the supply side to outweigh the benefits achieved on the demand side of the economy (Wahid, 2002, pp. 68).

Another issue that krugman examines in his book is the issue of currency crisis experienced in the world in 1990s such as the 1992 European monetary system collapse and the collapse of currencies in many Latin countries as a result of the collapse of peso in Mexico. In the light of his work, Krugman suggests that many of the currency crises in the world economy results from perceptions and opinions held by investors. In essence, financial crisis in many parts of the world are caused by changes in the investment trends with investors investing in emerging markets even when there are still crisis and later withdrawing their capital from the market even if it means selling the various assets at low prices than necessary. As Krugman suggests, changes in the opinions of the investors should be controlled through the use of capital controls so that such changes are prevented from damaging the economy.

As has been witnessed over the last years, the free flow of international capital has given rise to international financial crisis not just once but more than once and in short intervals. While it is not possible to block the flow of international capital as this would hinder industrialization of third world countries, for an economy faced by financial crisis, policy makers should use strategies aimed at depreciating the exchange rate. However, Keynesian compact as Krugman suggests has some limitations and cannot be applied in every kind of a situation which supports the Krugman premises that it should be done away with. For example, if an economy is to pay back an international debt through a different currency such as dollars or yen, then depreciating a currency will bankrupt such an economy. This is because depreciating the exchange rate affects the assets held by corporations, bank or even the government but does not affect the liabilities held by them. In essence, it would pose a problem of transforming savings into investment expenditure a thing that can result to a great depression.

For inflation to remain low, the stability of the currency needs to be maintained and large exchange rate depreciation poses a risk of a dangerous and harmful shift in the supply side of the economy. As such, depreciating the exchange rate is not an optimal solution either. In this context, preventing capital flights would require that the rate of interest be driven high. On the other hand, driving interest rates high will prevent investments and can lead to bankruptcies in the economy and by extension can be a cause of a great depression (Paul, 1999. pp, 14).

As Krugman argues, devaluation of a country’s currency should be done in a proper manner, one in which the rest of the world market is aware that the country in question will maintain a stable currency to the best of its capability. In this regard, Paul argues that devaluation should be done only once and to an extent that will avoid future devaluations.

Krugman seems to be right when he argues that it is a malpractice on economic policy makers’ side when they claim that the rate of interest should not be raised during a period of economic crisis. The same applies for those that advocates for a market free exchange rate. In essence, it is not easy to keep interest rates low and a free exchange rate while at the same time containing things like capital flight. In general, he does not deny the presence of weaknesses in policies adopted by various nations that have recently been involved in economic crisis. Moreover he recognizes the fact that the concept of crony capitalism does not present any foundation for industrialization as argued by Keynes but rather pose itself as an economic weakness (Thomas,2006, pp. 103).

Krugman is a hundred percent right when he points out that it has never been true to say a certain economic system can be managed and controlled through the use of perfect economic policies. In essence world economic systems and these includes even those of industrialized countries struggle to contain the weaknesses in economic policies adopted by the governments and practices in the private sector. In this light, one cannot blame the policy makers completely and insists their perfection of the policies they adopt as a condition to warrant outside assistance. Moreover, it would be illogical to withhold any form of economic assistance or to delay actions that can stimulate an economy that is faced with the risk of deep recession or other economic crisis. However, this does not necessarily mean that loopholes in the economic policies adopted should not be taken care of though any reforms adopted may not be essential in preventing the economy from facing a crisis. In any case, there is evidence that thriving economies are also vulnerable to economic crisis despite the policies adopted.

Krugman argues that though the policy instrument advised by Keynes may not be applicable in every situation they are still good to advice in periods of economic crisis. For example, monetary expansion policy tool and programs that represent deficit spending by the government should be adopted during a period of economic crisis in an effort to ensure that there is enough demand thus full utilization of the available productive resources such that an affected economy can once again be able to function properly.

However, as stated earlier, there are certain limitations to Keynesian policies. Firstly, countries that can be termed as soft currency nations suffers even more by when they adopt policies such as those aimed at expanding the home currency or deficit spending programs. In this context, these countries are often faced with the problem of capital flight when they adopt such policies and can plunge in more problems. A small, soft currency nation when fighting an economic crisis is advised to increase the confidence in their currency as a prerequisite for any form of progress in their efforts.

Secondly, Keynesian policies may not be applicable in economies where inflation rates are high. In essence, application of such policies would only create more problems for such an economy. According to Krugman, if a country is faced with such high inflation, the first essential step should be the restoration of confidence in the government and its monetary authorities before applying Keynesian policies. A good example is the Japan economy which after years of applying Keynesian policies has remained stagnant still (Thomas, 2006, pp. 102).

Paul Krugman still holds the view that Keynesian policies should be used as the first line remedies for any economic crisis and in an effort to increase the usage of all the productive resources. Moreover, rationalization of practices in the private sector and reforms in the economic policies adopted are good measures but they may not be essential as such thus political leaders and the policy makers should not lean much on changing the political policies that govern their economic systems but rather should embark on using all the available economic measures in containing the crisis. It would be irrational for example to introduce rationalization in the private sector just because the economy is faced with financial crisis. In any case, such rationalization should have been adopted long before the crisis occurred.

In his work, Krugman further argues that in the economy, business cycle poses a big threat to the capitalist free market and as such should not be tolerated. According to him, where insufficient demand in any free market occurs continuously, the free market is at the risk of collapsing despite all the benefits associated with it. It is possible to use Keynesian policies to save such a free market from the dangers posed by the business cycle.

There are some parts of Krugman work that is left open to questioning. For one, it does not seem right for him when referring to the views of the IMF and the US treasury to state that sound policy instruments are not sufficient for gaining the confidence of the market. For one, there are narrow and few options that can help in avoiding an economic crisis as a result of high interest rates or as a result of general bankruptcy. It would be impossible for hard currency nations who have inflation expectations or denominated debts which are connected with the exchange rates to apply effectively Keynesian policies (Paul, 2008, pp. 78).

Secondly, the key goal of IMF is to lend money to countries so that to provide such countries with more policy options as opposed to adopting policies that would see such countries in a better position. In essence, the IMF has to look for ways to retrieve money given to countries in form of loans if it is to survive as an institution. Moreover, he is wrong when he argues that in any time that an economic crisis occurs, economic books should be done away with. In essence, these books contain valuable information for economic students and it is invaluable to argue that they do not play a role in the overall management of the economy. Still, his argument that the current economic crisis could not be prevented and that it was nobody’s fault that they occurred is wrong. In essence, if policy tools were used earlier and in the proper manner, there would not be an economic crisis. In this context, it seems healthy to argue that something somewhere went wrong in the application of economic policies in countries that have experienced economic crisis during 1990s. It is however important to note that Paul Krugman got many thing right in his work and it is helpful to economic students and other people interested in economic readings despite the fact that it lacks footnotes (Todd, 2004, pp. 101).


Paul Krugman (1999). The Return of Depression Economics. New York, W.W. Norton, pp. 14

Paul Krugman (2008). The Return of Depression Economics and the Crisis of 2008. New York, W.W Norton, pp. 67, 78

Theodore Rosenof (1997). Economics in the Long Run: New Deal Theorists and Their Legacies, 1933-1993. United States, University of North Carolina Press, pp. 47

Thomas Homer (2006). The Upside of Down: Catastrophe, Creativity and the Renewal of Civilization. United States, Island press, 102, 103

Todd Knoop (2004). Recessions and Depressions: Understanding Business Cycles. Greenwood Publishing Group, pp. 101

Wahid Abu (2002). Frontiers of Economics: Nobel Laureates of the Twentieth Century. London, Greenwood Press, pp. 68