The return of the call for Keynes

"There is a history in all men's lives,

Figuring the nature of the times deceased;

The which observed, a man may prophesy,

With a near aim, of the main chance of things ..."

-- Shakespeare, "Henry IV, Part 2"

Early on in his classic 1978 study "Manias, Panics, and Crashes: A History of Financial Crises," economist Charles P. Kindleberger observed that bad times are good for books on financial meltdowns. There was lots of work on such crises during the 1930s, for example, but very little during the postwar boom. A spate of work on panics and crises appeared during the economically troubled decade of the 1970s, including Kindleberger's book.

In this vein, New York Times columnist Paul Krugman, perhaps the world's most famous economist, published a very good book in 1999 titled "The Return of Depression Economics" on the context, causes and consequences of the Latin American and Asian financial crises of the 1990s.

Krugman has now quickly revised his 1999 "analytical tract" under the title "The Return of Depression Economics and the Crisis of 2008."

Clearly, with the U.S. economy suffering and with Krugman's receipt in October of the Nobel Prize in economics, the author and his publisher saw an opportunity and seized it. Like location in real estate, timing is everything in the publishing world these days.

On Oct. 29, Krugman wrote on his blog that there would be no more posts until he finished revisions. Despite its rushed nature, though, the book is an exceptionally lucid and insightful updating of the story he told in 1999.

After retracing and lightly reconsidering his analyses of the Latin American and Asian crises of the '90s, Krugman homes in on the U.S. with three short but trenchant new chapters on the dot-com and housing bubbles ("Greenspan's Bubbles"), on the rise and pernicious economic effects of the "shadow banking" system, and on the handling and mishandling of today's financial crisis.

The new book concludes with Krugman's policy prescriptions on how to meet and turn back this threat.

According to Krugman, today's crisis in the U.S. was a long time coming. If the proximate cause was the bursting of the housing bubble, the first signs of which appeared in spring 2006, the ultimate causes were more complex and more deeply rooted, stretching back almost 30 years.

It is not surprising, of course, that the author, whose blog is called "The Conscience of a Liberal," pins much of the blame on America's laissez-faire macroeconomic regime. This regime, predicated on supply-side economics and deregulation, began to emerge in the late 1970s before becoming institutionalized during the Reagan era.

As a result, Krugman contends, we rejected the time-tested "Keynesian compact" whereby the U.S. government had committed itself to use monetary and especially fiscal policy to ensure that resources were fully deployed and aggregate demand kept strong. Furthermore, he says, we increasingly abdicated responsibility for regulating various sectors of the American economy, with banking and finance constituting Exhibit A.

In fact, it was in large part the rise in the 1990s of "shadow" banking institutions (banklike entities that operated with virtually no regulation) and the embrace by the principals associated therewith of very risky financial stratagems built on debt that underpinned both our housing bubble and other bubbles and crises throughout our global economy.

In order to solve today's problems, particularly the credit crunch, Krugman believes that we'll need at the very least to:

  • Inject huge amounts of capital into financial markets, much more than anyone is currently talking about.
  • Support weakened aggregate demand through robust government spending.
  • Regulate the business entities and economic sectors that got us into trouble in the first place.

And because the American financial contagion has spread beyond our shores, we'll have to coordinate our response with our partners abroad.

In many ways, then, these are the same policy prescriptions we used during 1930s. Just to be clear: Krugman is not suggesting that we're about to sink into another Great Depression. His book should be read, though, as an "analytical tract" espousing a return to the Keynesian compact and a liberal interventionist macroeconomic regime.

In arguing this way, Krugman joins a host of other prominent liberal writers on public policy who have pushed similar lines of late. Given the state of the economy, it's easy to understand why this argument has a certain appeal. Still, some questions remain.

Does laissez-faire economics really deserve all the blame for conditions today? If so, shouldn't this regime also get the credit for the rapid economic growth of the past 25 years, the renaissance of American entrepreneurship and the rise of the so-called new economy?

Krugman doesn't address these questions. Nor does he probe the short- and long-term opportunity costs of the Keynesian compact. He tells us the benefits but ignores the downsides. One can sidestep such questions when writing as a partisan columnist, but one should do more when writing as a professional economist. Clearly, a more nuanced and balanced assessment of the economic situation and of the benefits and costs of a liberal interventionist state would have done more to move forward the public policy debate.

Certainly, Krugman is capable of providing such an assessment. To paraphrase biographer Richard Brookhiser's observation about Alexander Hamilton, Paul Krugman is a know-it-all who actually does seem to know it all.

Sure, he is smug and self-congratulatory. Granted, he is a brutal score settler (see his sections on Alan Greenspan). But friend and foe alike will concede his brilliance and his sense of timing: In January 2009, Norton plans to release a paperback version of his book "The Conscience of a Liberal" with a new afterword, just in time for Inauguration Day.