[ deanlebaron home ]

 The Fear Economy 

By PAUL KRUGMAN
September 30, 2001

[Full Article on the NY Times website]

Copernic Summary:

The American economy is usually quick to shrug off the effects of disaster.

When Hurricane Andrew swept through South Florida in 1992, and again when the Northridge earthquake struck Southern California in 1994, the property damage was immense and the lives of millions of people were disrupted for months thereafter.

Yet few economists thought of either event as a threat to national prosperity, and if you look at a chart showing the growth of gross domestic product, it's quite hard to see any effects.

Although Sept. 11 was a human tragedy on a scale far greater than any of America's recent natural disasters, in monetary terms the immediate loss was not much more than one might have expected from a severe hurricane or earthquake.

Yet many people fear that the terror attack, unlike a hurricane or an earthquake, will have dire consequences for the economy -- indeed, that it may even tip the world into recession.

And though they are probably wrong, they could be right.

The reason they might be right has little to do with the nature of the calamity.

It's true that there is something especially horrific about a disaster that was an act of man rather than an act of God.

And the after-effects were unsettling: airlines losing hundreds of millions of dollars a day; empty airports, hotels and theaters; conventions canceled; Wall Street spiraling downward.

The main reason to worry about the economic fallout from the attack is not the attack itself, but the timing.

It's a story that takes us far afield in time and space -- to the Great Depression of the 1930's and to the difficulties of modern Japan.

The terrorists may have taken us into uncharted territory in many ways, but the economic landscape is fairly familiar, and we have some pretty good ideas about how to deal with the risks ahead.

It can reduce supply -- that is, it can interfere with the economy's ability to produce.

Or it can reduce demand -- that is, it can make people unwilling to buy the economy's products.

The answer is that for all the damage in Lower Manhattan, the impact on supply of the terrorist attack will be minor compared with the awesome scale of the United States economy.

Yes, the airlines are in financial trouble, and they have cut back flights and laid off tens of thousands of employees, and Boeing is scaling back in anticipation of canceled aircraft orders.

But the basic ability of the American economy to move people and products around the country has not been seriously impaired.

If you ask how much consumers will consume and investors invest over the next few months, the answer is determined largely by feelings -- what John Maynard Keynes called ''animal spirits.'' If frightened people decide not to spend, their nervousness can translate into a depressed economy.

So could the terror attack -- a very small thing in terms of its physical impact on the economy -- have a disproportionately large psychological impact?

After all, the Great Depression had no obvious cause at all.

So the reason to be concerned about the economic effects of terrorism is not the actual damage but the possibility that nervous consumers and investors will stop spending.

To answer that question we need to ask why in normal times it would be easy for economic policy to offset the psychological impact of tragedy on overall demand -- and why right now that may not be so easy.

The first line of defense against an economic slump is monetary policy: the ability of the central bank -- the Federal Reserve, the European Central Bank, the Bank of Japan -- to cut interest rates.

Lower interest rates are supposed to persuade businesses and consumers to borrow and spend, which creates new jobs, which encourages people to spend even more, and so on.

Specifically, interest-rate cuts have pulled the United States out of each of its big recessions over the past 30 years -- in 1975, 1982 and 1991.

In fact, for most of the past 40 years the only serious problem with interest-rate cuts as a policy has been that they work too well, tempting countries to pursue overly ambitious targets for growth and employment.

The conventional wisdom among economic analysts is that fiscal policy is not necessary to deal with most recessions, that interest-rate policy is enough.

Three years ago I wrote a paper for the Brookings Institution titled ''It's Baaack: Japan's Slump and the Return of the Liquidity Trap.'' The rather flip title was meant to convey the message that events in Japan -- a faraway country of which many Americans know little -- should trouble us, because they suggested that Japan's economic woes may not be unique.

But the results look more like a holding action than a truly effective defense.

And now, with debt piling up alarmingly, there is reason to worry whether even that holding action can long continue.

Economists refer to Japan's situation, in which a zero interest rate just isn't low enough to restart growth, as a ''liquidity trap.'' The point is that, other things being equal, ''liquid'' assets -- cash -- are better than bonds: you can't use a bond in a vending machine.

The only reason people are willing to invest in bonds is that unlike cash, they offer interest.

When the interest rate gets very low, this incentive disappears, and people just hoard cash instead.

So if even a zero interest rate isn't low enough to get consumers and businesses to spend, there's nothing more you can do with interest-rate policy; you're trapped.

To find another case of a liquidity trap, you have to go back to the United States in the 1930's.

In 1939 the interest rate on Treasury bills was effectively zero (strictly speaking, it was 0.02 percent), yet the economy was still stuck in a depression.

By the 1990's, hardly anybody even thought about the possibility of a liquidity trap, and those who did usually dismissed it as something that probably couldn't happen in real life.

If you have visited Japan recently you know that it does not look like a country in the midst of a depression.

There are strong similarities between Japan in the 1990's and the United States in the 1930's, but there is also a big difference.

One important answer -- which is, by the way, a reason not to panic in the current situation -- is that, being a modern country, Japan has not allowed its banks to fail.

Things didn't really fall apart until late in 1930, when a wave of bank runs swept across America, driving a third of the nation's banks out of business.

Today, no government would allow anything similar to happen.

In Japan, furthermore, the government has stepped in repeatedly to prop up the banks, merging weak banks with stronger ones and occasionally putting in big infusions of cash to cover the banks' losses.

There is much to criticize about this process, which has kept the banks alive but not restored them to health.

But by averting a banking crisis, Japan has helped protect the economy from any sudden collapse.

One Japanese worker in 10 was employed in the construction industry, far more than in other advanced countries.

For there is no question that enormous public spending has helped keep the economy from sliding into a true, unambiguous depression.

As one Japan expert, Adam Posen of the Institute for International Economics, points out, the record of the 1990's is unmistakable.

Every time the government tries to scale back its spending, as it did under Prime Minster Ryutaro Hashimoto back in 1997, the economy goes into a recession.

In that year, the nation's public debt was about 60 percent of G.D.P., about the average for advanced countries and slightly less than the figure for the United States.

It's almost twice the advanced-country average and 2.5 times the figure for the United States.

More specifically, the rise and fall of Japan's financial bubble sounds all too recognizable to post-millennial Americans.

Stock prices soar to levels that look insane using conventional criteria, but everyone agrees that in such a dynamic economy old rules no longer apply.

When Wall Street first began to show signs of irrational exuberance back in the middle of the 1990's, a few lonely voices warned that we might be about to develop a Japanese-style bubble.

But conventional wisdom said that this was nonsense, that our mature financial markets would never get that out of touch with reality.

By Sept. 10, however, the Fed had already cut rates seven times, and it was still hard to see where a recovery would come from.

Indeed, some business economists had started referring privately to the Fed chairman as ''Greenspan-san.'' Business investment was still falling, because corporations clearly invested way too much back when optimism was the rage.

Second, the attack opened the door to a large but temporary increase in government spending -- precisely the kind of fiscal policy some economists had wanted but which had seemed politically impossible before.

This spending package could quickly get much larger -- and provide an even bigger stimulus -- if, contrary to expectations, this does turn into a full-scale conventional war.

Finally, the terror attack also seems to have led to some favorable policy changes elsewhere in the world.

Here one can offer some slightly reassuring comparisons.

Both Japan and the United States had stock market bubbles, and they were of roughly equal size: between 1985 and 1989 the Nikkei, Japan's main stock index, tripled; between 1995 and 2000 the S.&P.

But Japan also had an equally large bubble in real estate and land prices.

I've never known whether to believe the famous factoid that the land under the Imperial Palace in Tokyo was worth more than all of California, but Japanese land prices certainly reached ridiculous levels.

And much of the bad debt that still troubles Japan was run up to support real estate speculation.

We had nothing comparable in this country.

Moreover, the United States has a marked advantage when it comes to demography.

Japan's persistent economic problem is that consumers want to save more than businesses want to invest.

One important reason for that, many analysts agree, is the combination of a low birth rate and a refusal to allow large-scale immigration.

An aging population tends to save a lot in preparation for retirement, and it's hard to get businesses to invest all those savings when they know that the working-age population will be shrinking for decades to come.

We have problems with an aging population here, too.

But they are nowhere near as severe, and our working-age population is still growing steadily.

In one way, however, our situation is actually worse than Japan's.

For the past decade, Japan has been an island of depression in a sea of prosperity, its economy stagnating even as other major economies -- ours in particular -- boomed.

That was, you might say, quite an achievement.

Deflation adds to the economy's problems, because it gives people an incentive to hoard cash instead of spending.

After all, prices are falling because the economy is depressed; now we've just learned that the economy is depressed because prices are falling.

If Japan slides into the abyss, that will have a direct adverse effect on our economy dwarfing anything the terrorists did.

Not long ago, the two lines of defense against slump that I described earlier -- interest-rate cuts and deficit spending -- were pretty much it as far as economists were concerned.

On the other hand, if they should turn out not to be enough, economists had few ideas about what might come next.

Now, however, it is widely understood that even if both conventional lines of defense fail, there is still a lot that you can do -- as long as you are willing to abandon conventional notions of prudence.

For example, normal practice forbids central banks to invest in anything other than short-term government debt, for fear that decisions about what to invest in will become politicized.

And since the short-term interest rate in Japan is already zero, there is nothing more that the Bank of Japan can do within the limits of normal practice.

Earlier this year Junichiro Koizumi, a maverick and reformer who is intensely disliked by political insiders, was nonetheless chosen as prime minister by the ruling party in response to public pressure.

Perhaps Shiokawa is still traumatized by the wartime inflation of his youth.

Meanwhile, the Bank of Japan, which directly controls monetary policy, has refused to do anything unconventional; incredibly, it refused to make any major changes in policy even after the terrorist attacks.

What I do fear is that a combination of factors -- the legacy of our bubble economy, the trouble in Japan and maybe the psychological impact of the terrorist action -- will drag us into a prolonged period of stagnation.

Here's my nightmare: America's recovery from its current slump, whenever it comes, is tentative and short-lived, because the business investment that drove our boom in the 1990's remains stagnant.

And the terrorist attack doesn't make it any more likely -- if anything, the fiscal response to terror should help give the economy a boost now, when there is a good chance of heading off the chance that we will slip into a Japanese-style trap.

What would make things really different, in a good way, would be effective leadership that recognizes the gravity of the situation, does not fail to act for fear of political repercussions or, worse yet, try to exploit the crisis for political ends -- leadership that is prepared to try unorthodox remedies if conventional solutions fail.

[ deanlebaron home ]