Workers and Economists: The Global Economy Has Left Keynes in Its Train

FIRST, DO NO HARM

By Paul Krugman

When a fire breaks out in a single-family home, firefighters know what they have to do. Fires in private houses are all pretty much alike. But when a fire breaks out in a warehouse, the firefighters make an effort to find out what is inside before they go to work, lest they do more harm than good. For example, if the warehouse is filled with highly flammable chemicals, dousing the building with water may spread the fire. In the end, the fire department must act regardless, but it is important to act on as much information as one can get about the nature of the problem.

I offer this homily because Ethan B. Kapstein uses an analogy with firefighting to claim that the West, faced with the economic difficulties of inequality and unemployment, has been paralyzed by too much debate over causes ("Workers and the World Economy," May/June 1996). He seems to believe that economic crises are like house fires, all pretty much the same. In particular, he seems to believe that the economic woes of advanced nations in the 1990s are basically similar to the problems of the 1930s. Deficit spending was the answer then and it is the answer now. Money should, therefore, be spent like water.

Economic crises, however, are not all the same, and the problems of the 1990s look very little like those of the 1930s. The good news is that while there is considerable dispute about the relative importance of some factors, economists have reached enough of a workable consensus about the nature of the problem to accommodate helpful policies. The bad news is that much, although not all, of what Kapstein has to say ignores this consensus, and that some of his policy recommendations are mischievous. They would either create the risk of renewed inflation and worsen the already shaky finances of Western governments, or they would contribute to the very policy paralysis Kapstein decries.

THE NOT-QUITE CONSENSUS

The economic difficulties of the advanced nations are not new. Unemployment in Europe has been rising steadily since the early 1970s, while inequality in the United States began rising sharply only a few years later. Nor have they failed to receive attention. Over these 20-plus years, hundreds of conferences and thousands of academic articles and official reports have addressed them. While there is not a total consensus -- there never is -- a widely held middle-of-the-road position can be summarized by two propositions.

The first proposition is that the problems of wages and employment are mainly -- forgive the jargon -- structural rather than cyclical. A cyclical economic problem is caused by inadequate demand and can be cured by adopting a more expansionary monetary and fiscal policy -- that is, spending more or taxing less. Structural economic problems cannot be solved in this way. Most economists now believe that the Great Depression was essentially cyclical; the slack in employment could have been taken up simply through an aggressive program of demand expansion. But the structural nature of Europe's unemployment was graphically demonstrated by the events of the late 1980s. The later stages of a broad business cycle recovery were marked by a noticeable increase in inflation (drastic in the case of the United Kingdom), despite the fact that the unemployment rate was still nearly nine percent. Demand had recovered, but unemployment could not fall below the nine-percent structural rate without triggering inflation.

What is wrong with trading off lower unemployment for slightly higher inflation? Not much, but that is the wrong question, because there is overwhelming evidence that inflation begets inflation. Suppose the Federal Reserve were to push the U.S. unemployment rate down from its current 5.5 percent to 4.5 percent. In the first year the inflation rate would probably rise only from its current 3 percent to 3.5 or 4 percent. But in the next year it would be 4 or 5 percent, the year after that 5 or 6 percent, and ever upward. The point, then, is not that inflation will explode if the unemployment rate is pushed too low. It is that a sustained effort to keep unemployment below the so-called nairu -- the non-accelerating-inflation rate of unemployment -- merely by stimulating demand will lead to an upward spiral of inflation. And though high rates of inflation would be slow to materialize, they would be equally hard to get rid of. Once the economy has developed six percent inflation, to get it back down to three percent would require a severe recession. Some countries have substantial room for demand expansion, most notably Japan. For the advanced nations as a whole, however, demand expansion is not a solution; indeed, it will only add new problems.

The second and somewhat more controversial proposition of the not-quite consensus is that the growth of international trade is not the main cause of the persistent rise in European unemployment and American inequality. Rather, the main source is a decline in the internal demand for less-skilled labor, probably driven in large part by technological change biased toward highly skilled workers. While Kapstein insists that time should not be wasted debating causes, he nonetheless finds time to pick sides in the dispute here, asserting that "as a general explanation, technology is unsatisfactory. It is never clearly distinguished from other kinds of capital, and there is no reason that its introduction must in principle reduce the wages of the unskilled."