THE RETURN OF

DEPRESSION ECONOMICS

By Paul Krugman

Norton. 176 pp. $23.95

Reviewed by Paul Blustein

The world was supposed to be finished with 1930s-style economic disasters. Economists figured out long ago that the 1929 stock market crash led to unnecessarily dreadful consequences because of mistakes that seem idiotic in hindsight, notably the Hoover administration's insistence on balancing the federal budget and keeping money tight. Yet in the past couple of years, as Paul Krugman observes, the global financial crisis besetting Asia, Russia and Brazil has produced economic devastation with a disturbing similarity to the Great Depression, even if it isn't quite as severe.

"The kind of economic trouble that the world has recently suffered is precisely the sort of thing we thought we had learned to prevent," Krugman writes. "Think of it this way: It is as if bacteria that used to cause deadly plagues, but that have long been considered conquered by modern medicine, were to reemerge in a form resistant to all the standard antibiotics."

That's vintage Krugman -- who, in a profession notorious for its inability to express itself clearly, enjoys a well-earned reputation for lively prose. In this book the M.I.T. economist uses his talent to good effect in explaining the global crisis, providing entertaining accounts of complex developments including the devaluation of the Thai baht, the woes afflicting Japan's economy, the attack on the Hong Kong dollar and the collapse of the Long Term Capital Management hedge fund.

The book suffers from unfortunate timing. It is landing on store shelves just as the crisis appears to be abating, which also undercuts the author's scathing critique of how the crisis was handled by the International Monetary Fund and the U.S. Treasury. (This is ironic, since the book was rushed into print as the outlook darkened early this year.) Still, it offers plenty of Krugmanesque insight for policymakers, experts and interested readers alike.

In the West, the crisis is often perceived as a sort of morality play, with the Asians in particular being punished for a host of faults -- crony capitalism, for example, and excessive bureaucratic control over private banks and companies. Krugman is scornful of this interpretation, noting that most of those vices were prevalent -- and some were even deemed to be virtues -- during the economic "miracle" years in countries such as Thailand, South Korea and Indonesia. While acknowledging that many of the crisis-stricken countries were far from perfect, Krugman argues that they were victimized by a panicky flight of investors who, once a selloff started, felt obliged to dump their holdings of, say, Indonesian rupiah or Brazilian reals lest they be left holding the bag.

"In each case the effect, the damage done, seems vastly disproportionate to the cause -- capital (capital market?) punishment imposed on economies guilty of nothing more than financial misdemeanors," he writes, adding that countries were more vulnerable to this sort of thing in the late 1990s because, at the urging of the West, they had opened up their financial markets to foreign investors.

And the really perverse part came when the crisis countries, in exchange for desperately needed loans from the IMF, were required to drive interest rates to sky-high levels and cut their budgets -- policies that, Krugman notes, "were almost exactly the reverse of what the United States does in the face of a slump." Shades of Herbert Hoover! -- and, in Krugman's view, a well-intentioned but dangerously misguided effort to satisfy investors' lust for austerity.

Trouble is, to drive home his point that the IMF "bungled" the crisis, Krugman relies on an argument that has been undercut in just the past couple of months. He contends that although some of the Asian countries receiving IMF aid appear to be staging recoveries, the poor results of the late-1998 rescue of Brazil should dispel any doubts about the wrongheadedness of the IMF's prescriptions for high interest rates and tough budget cuts. "At the time of writing [January 1999]," Krugman says, "J.P. Morgan was forecasting a 5 percent decline in Brazil's GDP, Salomon 6 percent; while these forecasts will surely be revised, it seems clear that Brazil is now set for a crisis at least as bad as Thailand's or Korea's."

Whoops. At the time of this writing, the Brazilian currency and stock market have soared from their early-1999 lows, and the country's economy is forecast to undergo only a mild recession (perhaps a 2 percent drop in output) this year. The stunning turnaround is to a large extent attributable to the actions taken by Brazil's new central bank chief, Arminio Fraga, who closely followed the IMF playbook after taking office March 3. In contrast to his predecessor's monetary dithering, Fraga kept a tight lid on the money supply and drove interest rates up until investors became convinced that he was serious about preventing a rekindling of inflation; now that they're convinced, he has let interest rates ease a bit.

Krugman's agenda is to advance a proposal he made amid great controversy last summer: that countries facing investor panics should eschew IMF-style austerity, and instead slap emergency controls on outflows of capital. In Krugman's view, when money is fleeing a country it's crazy for the government to blindly follow Hooverite prescriptions; better it should consider the strategy adopted by Malaysia, which announced last September that investors were prohibited from withdrawing their money for a year.

"Just as the right to free speech does not necessarily include the right to shout `Fire!' in a crowded theater," Krugman writes, "the principle of free markets does not necessarily mean that investors must be allowed to trample each other in a stampede."

Nicely put. But his book, which he claims to be aiming at "concerned people at large," would better serve such non-expert readers if it included an objective explanation of the problems his proposal would entail. Here's one: When countries limit inflows and outflows of capital, the incentive to reform their economies is reduced. Here's another: If the IMF (which abhors controls on capital outflows) started endorsing the idea, investors might become even more prone to yank their money out of countries at the slightest whiff of trouble, to avoid being locked in.

Despite its flaws, Krugman's book ought to provoke discomfort in the high councils of the IMF and Treasury, especially this observation: "Now as in the 1930's . . . one cannot defend globalization merely by repeating free-market mantras, even as economy after economy crashes. If we want to see more economic miracles, more nations making the transition from abject poverty to the hope of a decent life, we had better find answers to the newly intractable problems of depression economics."

Paul Blustein covers international economics for The Washington Post.