The ghosts of economics past

J. Bradford DeLong Former Assistant U.S. Treasury Secretary Project Syndicate

In Charles Dicken's great novel "A Christmas Carol," the soulless businessman Ebeneezer Scrooge is tormented by a visit from the Spirit of Christmas Past. Today, economists are similarly troubled by unwanted ghosts, as they ponder the reappearance of economic ills long thought buried and dead.

From Stephen Roach at Morgan Stanley to Paul Krugman at Princeton, to the Governors of the U.S. Federal Reserve and the senior staff at the European Central Bank, to almost everyone in Japan, economists all over the world are worrying about deflation. Their thoughts retrace the economic thinking of over fifty years ago, a time when economists concluded that the thing to do with deflation was to avoid it like the plague.

Back in 1933 Irving Fisher -- Milton Friedman's predecessor atop America's monetarist school of economists -- announced that governments could prevent deep depressions by avoiding deflation. Deflation -- a steady ongoing decline in prices -- gave businesses and consumers powerful incentives to cut spending and hoard cash. It reduced the ability of businesses and banks to service their debt, and might trigger a chain of big bankruptcies that would destroy confidence in the financial system, providing further incentives to hoard.

Such strong incentives to hoard rather than spend can keep demand low and falling, and unemployment high and rising, for a much longer time than even the most laissez-faire-oriented politician or economist had ever dared contemplate. Hence the Keynesian solution: Use monetary policy (lower interest rates) and fiscal policy (expanded government spending and reduced taxes) to keep the economy from ever approaching the precipice where deflation becomes possible.

But if this is an issue solved over 50 years ago, why is it haunting us now? Why is this menace a matter of grave concern in Japan today, and a threat worth worrying about in the United States?

In the late 1940s, those present at the creation of the post- World War II international economic order tried to create an international monetary system that would (a) allow for exchange rates stable enough for producers and consumers to escape the risks of excessive and irrational exchange rate fluctuations, (b) allow countries to follow their own domestic macroeconomic policies, and (c) prevent the catastrophic panics affecting not just individual banks but whole countries that produced the destructive international financial crisis of the Great Depression.

The result was the fixed-but-adjustable exchange rate system of Bretton Woods, which over time mutated into the floating-rate system of the 1980s. Then came the 1990s. All of a sudden tremendously destructive herd-driven financial crises were back: Mexico, Thailand, Korea, Brazil, and so on looked like nothing as much as the U.S. financial panic of 1873 or the Austrian Creditanstalt crisis of 1931.

Argentina's crisis at the end of 2001 looked remarkably like Argentina's Baring Brothers crisis of 1890 -- save that politicians and international bankers seem to have had a much better idea of what to do to minimize the damage in 1890 than they do today.

But if those who built the post-World War II international monetary system worked to guard against the dangers posed by panic-driven international financial crises, why are these financial devils back?

The truth is that economic policymakers are juggling sets of potential disasters, exchanging the one that appears most threatening for a threat that seems more distant. In the U.S., the Bush Administration is skeptical of the stimulative power of monetary policy and wants bigger fiscal deficits to reduce unemployment, hoping that the future dangers posed by persistent deficits -- low investment, slow growth, loss of confidence, uncontrolled inflation and exchange rate depreciation -- can be finessed, or will not become visible until after the Bush team leaves office.

In Europe, the European Central Bank believes that the danger of uncontrolled inflation following a loss of public confidence in its commitment to low inflation outweighs the costs of European employment that is far too high. In developing countries, capital controls to prevent financial crises are feared as obstacles to attracting the finance necessary for industrialization, and as potential sources of corruption as financial flows somehow pass through the hands of the Vice Minister of Finance's nephew-in-law.

Flexible exchange rates, designed to allow the market to signal when confidence in the currency is declining, also put exporters at a competitive disadvantage against foreign-country producers whose prices aren't batted around by unpredictable exchange rates. Even the import-substitution policies, now universally scorned, were originally adopted by the developing world for good (as well as bad) reasons: The protectionist shutting-off of developed-country markets during the Great Depression which had disastrous consequences for the developing economies.

The ghosts of economics' past return because the lessons of the present are always oversold. Politicians and policymakers advance their approach to economics as the "One True Doctrine." But what they are doing, however, is dealing with the biggest problem of the moment but at the price of removing institutions and policies that policymakers before them had put into place to control problems which they felt to be the most pressing.

Ebeneezer Scrooge's nocturnal visitors were able to convince him of the errors of his ways. Let's hope that today's economists also learn the lessons of their unwanted ghosts.

The writer is now Professor of Economics at the University of California, Berkeley.