The following is an excerpt from Paul Krugman's latest book.  Dr. Krugman is a well known economist from M.I.T.  He is a columnist for several magazines and will be writing for the New York Times soon.  His goal in moving from academic writing to more popular media is to try make economic theory more understandable to the general public.    For those of you who find his style engaging and would like to continue to expand your economic knowledge, I would recommend this book or The Accidental Theorist.  You can visit his home page and get many of his past columns by linking to: http://web.mit.edu/krugman/www/

The Return of Depression Economics

by Paul Krugman, Norton Press 1999

The Taming of the Business Cycle

            The great enemies of capitalist stability have always been war and depression. What George Bush -- who, to his misfortune, never had much interest in economics -- really meant by the New World Order was not so much the triumph of capitalism as the supposed emergence, after the 1991 Gulf War, of an international system that would prevent future wars. Tell it to the Bosnians or the Rwandans. But the collapse of the Soviet Union did leave the United States with such an overwhelming monopoly of military power that it is hard to see how a major war could erupt in the foreseeable future.

             What about depression? The Great Depression came pretty close to destroying both capitalism and democracy, and led more or less directly to war. It was followed, however, by a generation of sustained growth in the industrial world, during which recessions were short and mild, recoveries strong and sustained. By the late 1960s the United States had gone so long without a recession that economists were holding conferences with titles like "Is the Business Cycle Obsolete?"

The question was premature: the 1970s were the decade of "stagflation," economic slump and inflation combined; and as I mentioned in the introduction, the two energy crises of 1973 and 1979 were followed by the worst recessions since the 1930s. But by the 1990s the question was being asked again; as unemployment fell year after year, as stock prices seemed to rise without limit, more and more pundits declared that we had indeed entered a new age of economic stability. In that golden July of 1997 Foreign Affairs published an article entitled "The End of the Business Cycle?" whose conclusion basically dropped the question mark. To much greater fanfare, in the same month Wired published Peter Schwartz and Peter Leyden's enthusiastic "The Long Boom: A History of the Future." Neither article, if read closely, claimed that the future would be free from occasional setbacks; but both did claim that the days of really severe recessions, let alone worldwide depressions, were behind us.

            How would you make up your mind about something like that, other than by noticing that the economy has not had a major recession lately? To answer that question we need to make a digression into theory and ask ourselves what the business cycle is all about in the first place. In particular, why do market economies experience recessions?

            Whatever you do, don't say that the answer is obvious -- that recessions occur because of X, where X is the prejudice of your choice. The truth is that if you think about it -- especially if you understand and generally believe in the idea that markets usually manage to match supply and demand -- a recession is a very peculiar thing indeed. For during an economic slump, especially a severe one, supply seems to be everywhere and demand nowhere. There are willing workers but not enough jobs, perfectly good factories but not enough orders, open shops but not enough customers. It's easy enough to see how there can be a shortfall of demand for some goods: if manufacturers produce a lot of Beanie Babies, but it turns out that consumers want Furbys instead, some of those Beanie Babies may go unsold. But how can there be too little demand for goods in general? Don't people have to spend their money on something?

            Part of the problem people have in talking sensibly about recessions is that it is hard to picture what is going on during a slump, to reduce it to a human scale. But I have a favorite story that I like to use, both to explain what recessions are all about and as an "intuition pump" for my own thought. (Readers of my earlier books have heard this one before.) It is a true story, although in Chapter 4 I will use an imaginary elaboration to try to make sense of Japan's malaise.

            The story is told in an article by Joan and Richard Sweeney, published in 1978 under the title "Monetary Theory and the Great Capitol Hill Baby-sitting Co-op Crisis." Don't recoil at the title: this is serious.

            During the 1970s the Sweeneys were members of, surprise, a baby-sitting cooperative: an association of young couples, in this case mainly people with congressional jobs, who were willing to baby-sit each other's children. This particular co-op was unusually large, about 150 couples, which meant that there were plenty of potential baby-sitters, but also that managing the organization -- especially making sure that each couple did its fair share -- was not a trivial matter.

Like many such institutions (and other barter schemes), the Capitol Hill co-op dealt with the problem by issuing scrip: coupons entitling the bearer to one hour of baby-sitting. When babies were sat, the baby-sitters would receive the appropriate number of coupons from the baby-sittees. This system was, by construction, shirkproof: it automatically ensured that over time each couple would provide exactly as many hours of baby-sitting as it received.

            But it was not quite that simple. It turns out that such a system requires a fair amount of scrip in circulation. Couples with several free evenings in a row, and no immediate plans to go out, would try to accumulate reserves for the future; this accumulation would be matched by the running down of other couples' reserves, but over time each couple would on the average probably want to hold enough coupons to go out several times between bouts of baby-sitting. The issuance of coupons in the Capitol Hill co-op was a complicated affair: couples received coupons on joining, were supposed to repay them on leaving, but also paid dues in baby-sitting coupons that were used to pay officers, and so on. The details aren't important; the point is that there came a time when relatively few coupons were in circulation -- too few, in fact, to meet the co-op's needs.

The result was peculiar. Couples who felt their reserves of coupons to be insufficient were anxious to baby-sit and reluctant to go out. But one couple's decision to go out was another's opportunity to baby-sit; so opportunities to baby-sit became hard to find, making couples even more reluctant to use their reserves except on special occasions, which made baby-sitting opportunities even scarcer . .

            In short, the co-op went into a recession.

            Okay, time out. How do you react to being told this story?

            If you are baffled -- wasn't this supposed to be a book about the world economic crisis, not about child care? -- you have missed the point. The only way to make sense of any complex system, be it global weather or the global economy, is to work with models -- simplified representations of that system which you hope help you understand how it works. Sometimes models consist of systems of equations, sometimes of computer programs (like the simulations that give you your daily weather forecast); but sometimes they are like the model airplanes that designers test in wind tunnels, small-scale versions of the real thing that are more accessible to observation and experiment. The Capitol Hill Baby-sitting Co-op was a miniature economy; it was indeed just about the smallest economy capable of having a recession. But what it experienced was a real recession, just as the lift generated by a model airplane's wings is real lift; and just as the behavior of that model can give designers valuable insights into how a jumbo jet will perform, the ups and downs of the co-op can give us crucial insights into why full-scale economies succeed or fail.

            If you are not so much puzzled as offended -- we're supposed to be discussing important issues here, and instead you are being told cute little parables about Washington yuppies -- shame on you. Remember what I said in the introduction: whimsicality, a willingness to play with ideas, is not merely entertaining but essential in times like these. Never trust an aircraft designer who refuses to play with model airplanes, and never trust an economic pundit who refuses to play with model economies.

            As it happens, the tale of the baby-sitting co-op will turn out to be a powerful tool for understanding the not at all whimsical problems of real-world economies. The theoretical models economists use, mainly mathematical constructs, often sound far more complicated than this; but usually their lessons can be translated into simple parables like that of the Capitol Hill co-op (and if they can't, often this is a sign that something is wrong with the model). I will end up returning to the baby-sitting story several times in this book, in a variety of contexts. For now, however, let's consider two crucial implications of the story: one about how recessions can happen, the other about how to deal with them.

            First, why did the baby-sitting co-op get into a recession? It was not because the members of the co-op were doing a bad job of baby-sitting: maybe they were, maybe they weren't, but anyway that is a separate issue. It wasn't because the co-op suffered from "Capitol Hill values," or engaged in "crony baby-sittingism," or had failed to adjust to changing baby-sitting technology as well as its competitors. The problem was not with the co-op's ability to produce, but simply a lack of "effective demand": too little spending on real goods (baby-sitting time), because people were trying to accumulate cash (baby-sitting coupons) instead. The lesson for the real world is that your vulnerability to the business cycle may have little or nothing to do with your more fundamental economic strengths and weaknesses: bad things can happen to good economies.

            Second, in that case, what was the solution? The Sweeneys report that in the case of the Capitol Hill co-op it was quite difficult to convince the governing board, which consisted mainly of lawyers, that the problem was essentially technical, with an easy fix. The co-op's officers at first treated it as what an economist would call a "structural" problem, requiring direct action: a rule was passed requiring each couple to go out at least twice a month. Eventually, however, the economists prevailed, and the supply of coupons was increased. The results were magical: with larger reserves of coupons couples became more willing to go out, making opportunities to baby-sit more plentiful, making couples even more willing to go out, and so on. The co-op's GBP -- gross baby-sitting product, measured in units of babies sat -- soared. Again, this was not because the couples had become better baby-sitters, or that the co-op had gone through any sort of fundamental reform process; it was simply because the monetary screwup had been rectified. Recessions, in other words, can be fought simply by printing money -- and can sometimes (usually) be cured with surprising ease.

And with that let us return to the business cycle in the full-scale world.

            The economy of even a small nation is, of course, far more complex than that of a baby-sitting co-op. Among other things, people in the larger world spend money not only for their current pleasure but to invest for the future (imagine hiring co-op members not to watch your babies but to build a new playpen). And in the big world there is also a capital market, in which those with spare cash can lend it at interest to those who need it now. But the fundamentals are the same: a recession is normally a matter of the public as a whole trying to accumulate cash (or, what is the same thing, trying to save more than it invests) and can normally be cured simply by issuing more coupons.

            The coupon issuers of the modern world are known as central banks: the Federal Reserve, the Bank of England, the Bank of Japan, and so on. And it is their job to keep the economy on an even keel by adding or subtracting cash as needed.

But if it's that easy, why do we ever experience economic slumps? Why don't the central banks always print enough money to keep us at full employment?

            Before World War II, the answer seems fairly straightforward: policy was ineffective because policymakers didn't know what they were doing. Nowadays practically the whole spectrum of economists, from Milton Friedman leftward, agrees that the Great Depression was brought on by a collapse of effective demand and that the Federal Reserve should have fought the slump with large injections of money. But at the time this was by no means the conventional wisdom. Indeed, many prominent economists subscribed to a sort of moralistic fatalism, which viewed the Depression as an inevitable consequence of the economy's earlier excesses, and indeed as a healthy process: recovery, declared Joseph Schumpeter, "is sound only if it [comes] of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another [worse] crisis ahead."

Such fatalism vanished after the war, and for a generation most countries did try actively to control the business cycle, with considerable success; recessions were mild, and jobs were usually plentiful. By the late 1960s many started to believe that the business cycle was no longer a major problem; even Richard Nixon promised to "fine-tune" the economy.

            This was hubris; and the tragic flaw of full-employment policies became apparent in the 1970s. If the central bank is overoptimistic about how many jobs can be created, if it puts too much money into circulation, the result is inflation; and once that inflation has become deeply embedded in the public's expectations, it can be wrung out of the system only through a period of temporarily high unemployment. Add in some external shock that suddenly increases prices -- such as a doubling of the price of oil -- and you have a recipe for nasty, if not Depression-sized, economic slumps.

            But by the middle of the 1980s inflation had fallen back to tolerable levels, oil was in abundant supply, and central bankers finally seemed to be getting the hang of economic management. Indeed, the bad things that happened seemed, if anything, to reinforce the sense that we had finally figured this thing out. In 1987, for example, the U.S. stock market crashed -- with a one-day fall that was as bad as the first day's fall of the 1929 crash. But the Federal Reserve pumped cash into the system, the real economy didn't even slow down, and the Dow soon recovered. At the end of the 1980s central bankers, worried about a small rise in inflation, missed the signs of a developing recession and got behind the curve in fighting it; but while that recession cost George Bush his job, eventually it responded to the usual medicine, and the United States entered into another period of sustained expansion. By the summer of 1997 it did indeed seem that the business cycle, if it had not been eliminated, had at least been decisively tamed.

            Much of the credit for that taming went to the money managers: never in history has a central banker enjoyed quite the mystique of Alan Greenspan. But there was also a sense that the underlying structure of the economy had changed in ways that made continuing prosperity more likely.