Currencies and Crises.

Ho Li, Jane-yu

This is Krugman's second book of collected essays. He describes this volume as having more immediate real-world relevance than the first one, Rethinking International Trade, in the sense that he has attempted to decipher the rapidly changing world of international monetary matters. He admits that this effort is sometimes made at the expense of intellectual coherence. Despite that concern, he manages to maintain the reader's interest in and enthusiasm about his subject matter with various styles of his writing.

In Krugman's theoretical papers, he keeps his analytical models small and insightful. He makes an admirable attempt to link his theoretical work to the empirical evidence. As usual, he challenges some prevailing thinking. Krugman also debunks some conceptions popular in policy debates. Among other things, he points out the lack of a theoretical foundation in most of policy packages proposed to solve the Third World debt problem. Perhaps his most useful service is his articulation of the criteria and processes used to design models. In so doing, he shows a thorough understanding of the value and limitations of theoretical economic models. Economic theories are ultimately useful only if they can increase our understanding of real world by making sense of its intricacies. Without serving this purpose, theories can only be helpful in training students' ability to make logical deductions, while leaving real world problems unsolved. Consequently, real world problems would be resolved either by policy prescribed without much theoretical foundation or prescribed solely from ideological commitment. Neither solution would be desirable. Krugman's eleven essays cover four key areas: the role of exchange rate in balance-of-trade adjustment policy, the role of speculation in the functioning of exchange rate regimes, the Third World debt and proposed solutions, and the construction of an international monetary system. Because economists were often surprised by some international monetary developments and market responses to policies in the past two decades, Krugman believes economists' understanding of international monetary economics is inadequate. Therefore, his papers are aimed at improving the situation.

The first part of Krugman's book contains three chapters. The rise and fall of the U.S. dollar in the 1980s reactivated the debate about the role of exchange rates in helping adjust a country's balance of payments. According to Krugman, several influential economists (including Ronald McKinnon and Robert Mundell) have denounced the traditional view that a country can most easily reduce a trade deficit by depreciating its currency. They argued that the growing international mobility of capital has ended the usefulness of the exchange rate adjustment. Krugman takes issue with their views in chapter one. He examines the view that the trade deficit can be reduced by lowering the budget deficit without working through the change in exchange rates. He points out the uncertainty in the relation between the budget deficit and the trade deficit. He also challenges the description of foreign acquisitions of U.S. assets as that of a "fire sale" in a cheap dollar situation. He views that outcome as an inevitable part of the adjustment process and rationalizes the low prices of assets as an indication that foreigners had a lessened confidence in the United States as a safe haven in later part of the 1980s. His arguments are often persuasive. It is less clear, however, that he has correctly presented the view of the international monetarists. A commentator's remark or a rebuttal from McKinnon or Mundell would have helped to clarify this point.

Chapter one thus works as a defense of U.S. policy on exchange rate adjustment which he originally presented to the Group of Thirty in 1987. Chapter two examines the evolving views of both optimists and pessimists regarding the situation of the U.S. trade deficit and the value of the dollar before and after the major dollar devaluation in 1985-87.

In chapter three, Krugman recognizes that real exchange rates seem to have changed little over the long term and examines the role played by different income elasticities between Japan and the United States in explaining this condition. He tries to tie this phenomenon to his new trade theory, i.e., that artificial specialization and economies of scale enable Japan to increase its range of exports over time; these conditions are then reflected in higher aggregate income elasticity for Japan's exports.

This explanation seems a bit farfetched. I would rather revise it: As nations develop, they can produce a wider range of goods, and so on. I would call this explanation the "development-trade theory", instead. The second part of Krugman's book deals with exchange rate speculation and consists of three chapters. Krugman brilliantly designs versions of a small size model with one commodity and two assets. He explains the behavior of speculation attacks under various exchange rate regimes - fixed, floating, and target zones. He uses these models as a tool to teach students how insightful models can be designed. He theorizes that balance-of-payment crises are a natural outcome of maximizing behavior by investors, when the government's willingness (or credibility) to defend the rate is uncertain. He also builds a model in which exchange rate values can fall within the target zone normally. He reaches some surprising findings - his analysis turns out to be similar to that of option pricing and irreversible investment models. These models should be of great interest to finance economists. It should be noted, however, that as the complexity of Krugman's models increases, the training that his readers must have increases as well. Nevertheless, it is comforting to see that Krugman always makes an effort to tell his story in plain English before he presents his model.

The third part of the book, consisting of three chapters, deals with Third World debt issues. It is a detour from the main discussions of exchange rates and balance-of-payment mechanisms. This section is useful for analysts who follow the related policy issues. Krugman tries to provide analytical concepts to help decide what debt strategy was appropriate.

The fourth and last part of Krugman's book, consisting of two chapters, discusses the international monetary system. Krugman reexamines the role of the U.S. dollar in 1984 and compares it to the role of sterling in the early decade of the century. In one recent (1990) paper included in this part, he discusses the rationale behind the European monetary union. He begins with some discussion on the optimum currency area, then moves on to policy coordination and the credibility of government actions. Even though he calls the literary style used in this article a "rambling essay," it still provides interesting reading.