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When is a Government Failure not a Government Failure?

by on March 5, 2011

I just recently finished reading Paul Krugman’s book The Return of Depression Economics and overall I thought it was excellent. Although I disagree with Krugman on plenty, I think he is one of the best economic writers around. Actually, I think he’s one of the better writers in general. I’m a big fan of well written prose, so I always enjoy reading his stuff.

I also enjoyed the book for its historical information. Throughout the book he goes through a few of the major crises that have struck the world economy over the past couple of decades. I wasn’t very familiar with most of them, including the Mexican and Latin American crisis in the mid-’90s, the Japanese “lost decade”, and the Asian crisis in the late ’90s. Seeing as those were some pretty significant economic events, it’s good to have a basic understanding of what went wrong.

I confess that I was a bit skeptical going into this book about Krugman’s ability to be objective. Perhaps this is due to the amount of time I have spent reading Austrian-oriented writers (although I have stayed far away from William Anderson’s Krugman-in-Wonderland blog because I find that a blog devoted to one person is a bit creepy/obnoxious),  but I’ve always viewed Krugman as someone who would readily sacrifice economic truth to politics. I could be completely wrong here, although I have seen some evidence to support that view of him. I think I agree most with Pete Boettke, who once wrote that Krugman is…

…not a political economist, he is a politicized economist

Unfortunately, after reading Depression Economics, my views on him have not changed much. Let me explain. Throughout the book, Krugman almost consistently paints every crisis he comes to as a failure of government. Now, he doesn’t really come out and say that quite so explicitly, but he implies it very strongly. This surprised me, to say the least. For example, when setting the stage for Japan’s decade long period of stagnation he writes that

…in Japan as in most countries, depositors  believed that the government  would never allow them to lose their savings, so they paid little attention to what banks did with their money. [p. 60]

In other words, moral hazard was a problem in Japan. A little further down that same page he writes that,

Only much later would those same distinctive characteristics- the cozy relationship between government and business, the extension of easy credit by government-guaranteed banks to closely allied companies- come to be labeled crony capitalism and seen as the root of the economic malaise.

Throughout the chapter he makes it very clear that moral hazard and cheap credit were the primary reasons Japan first became a bubble economy. Banks, being implicitly (and in some cases explicitly) backed by the government, made lots of bad loans and so forth. This led to a quickly growing bubble in Japan’s economy as land and stock prices tripled during the 1980s, and then- bam– everything popped. Summary: government caused market-failure.

In the next chapter on the Asian crisis that struck Thailand, South Korea, Malaysia, and Indonesia in the late 1990s, the narrative is strikingly similar. Once again, there was a very cozy relationship between Thai banks and the government, and moral hazard led the banks to make all sorts of risky loans. Eventually things started to go south and investors pulled out of Southeast Asian altogether, which caused the Thai crisis to spread to neighboring countries. Krugman puts it this way:

What we also should have noticed [referring to economists in general] was that the claim that Asian borrowing represented free private-sector decisions was not quite the truth. For Southeast Asia, like Japan in the bubble years, had a moral hazard problem- the problem that would soon be dubbed crony capitalism. [p. 82]

Krugman also notes that moral hazard wasn’t the only problem plaguing Thailand’s economy; a fixed exchange rate, with the Thai baht fixed to the dollar, was the other problem. As the economy began to slow and foreign investors pulled dollars out of the economy, the demand for baht fell. The Bank of Thailand, however, was still forced to maintain the same exchange rate between dollars and baht, which meant that it was forced to draw down its reserves of dollars and exchange them for baht in the hopes that that would be enough to keep the value of the baht on par with its fixed exchange rate. The Bank of Thailand’s reserves of dollars were limited, though, and would eventually run out. They could either suck baht out of the economy (which would raise interest rates and put a brake on growth) or they could devalue (which they eventually did).

So here we have a history which puts the blame on precisely two non-market failures: moral hazard and fixed exchange rates, neither of which can be convincingly tied back to the market. If Krugman had stopped there I would have a lot more respect for the guy. Granted, all of his solutions to the aforementioned problems involve either increasing the supply of money to induce inflation expectations (especially in the case of Japan) or deficit spending to increase aggregate demand, or a combination of those. Still, at least he would have decisively demonstrated that in regards to the largest crises throughout the 1990s, the problems originated with mistaken government policies. That, at least, would have been something in the defense of markets.

Instead, Krugman deceptively tries to pass these problems off as market failures. Yes, after explicitly pointing out where government policies went wrong and why none of these collapses could be tied to any country’s private sector, he tries to paint markets as unstable and prone to panics, animal spirits, and total collapse at the drop of a dime. Nowhere in the book does he ever say, “markets work fine when governments don’t screw things up.” At one point, towards the end of the chapter on the Southeast Asian crisis, he writes that,

Indeed, even now there are many people who find it hard to believe that a market economy can really be that unstable, that the feedbacks illustrated in the figure can really be strong enough to create an explosive crisis. [p. 91]

Indeed, how could someone possibly believe that market economies could be so unstable? I mean, it isn’t like moral hazard and governmentally fixed exchange rates could ever be the cause of that instability, even though Krugman stated that they were just a few pages back.

Krugman makes a decent enough case that the government should become involved once the market tanks, but the overarching theme I take from his book is that the government shouldn’t become involved in the first place! That’s what surprised me so much about the book. Krugman- the Paul Krugman- has made a perfectly cogent historical argument that without intervention into the market, these recessions would never have materialized.

So, in one sense I found the book to be highly educational and enjoyable to read; on the other hand, I found that I had to look below the surface to really understand what was going on, because Krugman would try to incorrectly place the blame almost 100% of the time. Someone reading it with an uncritical eye would come away thinking that markets were the culprit in every single case when the exact opposite is true.

I do recommend this book, but with one caveat: read between the lines.

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From → Economics

2 Comments
  1. I’ve never read the book, but I’m not sure I entirely understand the argument here. Must we choose between market failure and government failure? I’ve always been under the impression that both occur. I don’t know about Mexico and the Asian crises, but Krugman has done a lot to outline the market failures involved with Japan, at the same time (as you say) he hasn’t been shy about highlighting government failure. I think people have a natural tendency to do three things:

    1. Assume that either the market fails or the government fails, but not both
    2. Assume that if the market fails, the market is not a worthwhile institution (or if people say the market fails, they think it is not a worthwhile institution), and
    3. Ignore the importance of good government – instead pointing to bad government and saying “see, let’s just get the government out of here”.

    I think all three of those are bad tendencies. I wouldn’t be surprised if Krugman doesn’t make an entirely sufficient case for market failure before asserting it – perhaps he thought the point didn’t need to be made, I don’t know.

    Are you reading the newer version? Did he note, at all, whether much of the text of the older version was adjusted (I know he added a new chapter). I ask because I have a copy of the older version that I’ve never read and I’m wondering if I oughta just get the new one.

  2. Sam permalink

    Must we choose between market failure and government failure?

    No, I don’t think we necessarily do have to choose between one or the other. As I said above, Krugman makes a decent enough case that once a recession has kicked in, the government needs to step in and do what it has to do. A situation like that is probably a case of market failure, or, in other words, the market’s inability to grapple with an exogenous shock (as Lord Keynes put it in my previous post). I’m not totally convinced by his arguments in those cases, but they’re not bad arguments by any means.

    I think it was his emphasis that I didn’t like. If you read it, you may come away with a different impression, but I felt like the “point” about government failure was a point he definitely needed to make, but never did quite so explicitly. Yet, he wasn’t shy about pointing out where the market failed.

    To me it seemed like he would go along setting the stage, pointing out moral hazard and the problems of fixed-exchange rates, and then the market would go bust and he would spend the rest of the time talking about how unstable markets are. But if you simply follow his line of reasoning, that wasn’t really the argument he was making. He was making an argument that, at least in the historical examples in the book, those markets were fine until government policies messed things up.

    He just came off as being a bit duplicitous to me. You should definitely read it, though, and let me know what you think about it.

    Oh, and he says he added new material, but I can’t figure out if he’s referring only to the new chapter or if he did add new material to the previously written chapters. Not having the older one to compare it to, I can’t be sure. The chapter on the housing crisis wasn’t really all that interesting simply because I’ve already read so much on the housing crisis to begin with and he didn’t give it a very detailed explanation. His other chapters were interesting to me because he laid out very clearly and concisely what happened, but I suppose that if I had spent many years reading about Japan’s lost decade, Krugman’s chapter wouldn’t be all that riveting. So, I think you should be fine reading the older version. I don’t think you’ll miss much.

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