Once upon a time
there was a densely populated island nation, which, despite its lack of
natural resources, had managed through hard work and ingenuity to build
itself into one of the world's major industrial powers. But there came
a time when the magic stopped working. A brief, overheated boom was followed
by a slump that lingered for most of a decade. A country whose name had
once been a byword for economic prowess instead became a symbol of faded
Inevitably, a dispute raged over the causes of and cures for the nation's malaise. Many observers attributed the economy's decline to deep structural factors--institutions that failed to adapt to a changing world, missed opportunities to capitalize on new technologies, and general rigidity and lack of flexibility. But a few dissented. While conceding these factors were at work, they insisted that much of the slump had far shallower roots--that it was the avoidable consequence of an excessively conservative monetary policy, one preoccupied with conventional standards of soundness when what the economy really needed was to roll the printing presses.
Needless to say, the "inflationists" were dismissed by mainstream opinion. Adopting their proposals, argued central bankers and finance ministry officials, would undermine confidence and hence worsen the slump. And even if inflationary policies were to give the economy a false flush of artificial health, they would be counterproductive in the long run because they would relax the pressure for fundamental reform. Better to take the bitter medicine now--to let unemployment rise, to force companies to purge themselves of redundant capacity--than to postpone the day of reckoning.
OK, OK, I've used this writing trick before. The previous paragraphs could describe the current debate about Japan. (I myself am, of course, the most notorious advocate of inflation as a cure for Japan's slump.) But they could also describe Great Britain in the 1920s--a point brought home to me by my vacation reading: the second volume of Robert Skidelsky's biography of John Maynard Keynes, which covers the crucial period from 1920 to 1937. (The volume's title, incidentally, is John Maynard Keynes: The Economist as Savior.)
Skidelsky's book, believe it or not, is actually quite absorbing: Although he was an economist, Keynes led an interesting life--though, to tell the truth, what I personally found myself envying was the way he managed to change the world without having to visit quite so much of it. (Imagine being a prominent economist without once experiencing jet lag, or never taking a business trip where you spent more time getting to and from your destination than you spent at it.) And anyone with an interest in the history of economic thought will find the tale of how Keynes gradually, painfully arrived at his ideas--and of how his emerging vision clashed with rival schools of thought--fascinating.
But the part of Skidelsky's book that really resonates with current events concerns the great debate over British monetary policy in the 1920s. Like the United States, Britain experienced an inflationary boom, fed by real estate speculation in particular, immediately following World War I. In both countries this boom was followed by a nasty recession. But whereas the United States soon recovered and experienced a decade of roaring prosperity before the coming of the Great Depression, Britain's slump never really ended. Unemployment, which had averaged something like 4 percent before the war, stubbornly remained above 10 percent. There is an obvious parallel with modern Japan, whose "bubble economy" of the late 1980s burst eight years ago and has never bounced back.
Almost everyone who thought about it agreed that Britain's long-run relative decline as an economic power had much to do with structural weaknesses: an overreliance on traditional industries such as coal and cotton, a class-ridden educational system that still tried to produce gentlemen rather than engineers and managers, a business culture that had failed to make the transition from the family firm to the modern corporation. (Keynes, never one to mince words, wrote that "[t]he hereditary principle in the transmission of wealth and the control of business is the reason why the leadership of the Capitalist cause is weak and stupid. It is too much dominated by third-generation men.") Similarly, everyone who thinks about it agrees that modern Japan has deep structural problems: a failure to move out of traditional heavy industry, an educational system that stresses obedience rather than initiative, a business system that insulates big company managers from market reality.
But need structural problems of this kind lead to high unemployment, as opposed to slow growth? Is recession the price of inefficiency? Keynes didn't think so then, and those of us who think along related lines don't think so now. Recessions, we claim, can and should be fought with short-run palliatives; by all means let us work on our structural problems, but meanwhile let us also keep the work force employed by printing enough money to keep consumers and investors spending.
One objection to that proposal is that it will directly do more harm than good. In the 1920s the great and the good believed that an essential precondition for British recovery was a return to the prewar gold standard--at the prewar parity, that is, making a pound worth $4.86. It was believed that this goal was worth achieving even if it required a substantial fall in wages and prices--that is, general deflation. To ratify the depreciation of the pound that had taken place since 1914 in order to avoid that deflation was clearly irresponsible.
In modern times, of course, it would, on the contrary, seem irresponsible to advocate deflation in the name of a historical monetary benchmark (though Hong Kong is currently following a de facto policy of deflation in order to defend the fixed exchange rate between its currency and the U.S. dollar). But orthodoxy continues to prevail against the logic of economic analysis. In the case of Japan, there is a compelling intellectual case for a recovery strategy based on the deliberate creation of "managed inflation." But the great and the good know that price stability is essential and that inflation is always a bad thing.
What really struck me in Skidelsky's account, however, was the extent to which conventional opinion in the 1920s viewed high unemployment as a good thing, a sign that excesses were being corrected and discipline restored--so that even a successful attempt to reflate the economy would be a mistake. And one hears exactly the same argument now. As one ordinarily sensible Japanese economist said to me, "Your proposal would just allow those guys to keep on doing the same old things, just when the recession is finally bringing about change."
In short, in Japan today--and perhaps in the United States tomorrow--behind many of the arguments about why we can't monetize our way out of a recession lies the belief that pain is good, that it builds a stronger economy. Well, let Keynes have the last word: "It is a grave criticism of our way of managing our economic affairs, that this should seem to anyone like a reasonable proposal."