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BookReview: The Return of Depression Economics and the Crisis of 2008
by Paul Krugman, W. W. Norton, December 1, 2008, 978-0393071016

Paul Krugman is a Nobel prize winner and generally renowned economist. This book does an excellent job of pointing out the way the econonomy is working today, and how it is related to various other crises. Well-written and thoughtful. I have various disagreements with Krugman, and those don't diminish the book's value to lay people and economists alike.

[k85] But I have tried to avoid making this a dry theoretical exposition. There are no equations, no inscrutable diagrams, and (I hope) no impenetrable jargon. As an economist in good standing, I am quite capable of writing things nobody can read. Indeed, unreadable writing--my own and others'--played a key role in helping me arrive at the views presented here.

[k114] In 2003 Robert Lucas, a professor at the University of Chicago and winner of the 1995 Nobel Memorial Prize in Economics, gave the presidential address at the annual meetings of the American Economic Association. After explaining that macroeconomics began as a response to the Great Depression, he declared that it was time for the field to move on: the "central problem of depression-prevention," he declared, "has been solved, for all practical purposes."

His openness to new ideas is refreshing. Krugman is also clear that socialism failed for political as well as economic reasons.

[k185] For the first time since 1917, then, we live in a world in which property rights and free markets are viewed as fundamental principles, not grudging expedients; where the unpleasant aspects of a market system--inequality, unemployment, injustice--are accepted as facts of life. As in the Victorian era, capitalism is secure not only because of its successes--which, as we will see in a moment, have been very real--but because nobody has a plausible alternative. This situation will not last forever. Surely there will be other ideologies, other dreams; and they will emerge sooner rather than later if the current economic crisis persists and deepens. But for now capitalism rules the world unchallenged. The great enemies of capitalist stability have always been war and depression. War,

[k203] 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.

[k244] 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.

[k255] 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.

[k269] 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.

I have a problem with simplistic views of full employment. People are not interchangeable. You cannot turn a car mechanic into a web developer overnight. As the economy of any country grows the jobs available become more plentiful, but they are often the wrong type of job. People do not adapt easily. It can take a decade to turn an independent car mechanic into a web devloper. Who pays that person for his education? How do you motivate that person to want to change? How do you know that web developers will be needed in 10 years?

[k283] 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 high unemployment.

[k311] And that sense of progress helped bring with it a new sense of optimism about capitalism. Moreover, the new industries brought back what we might call the romance of capitalism: the idea of the heroic entrepreneur who builds a better mousetrap, and in so doing becomes deservedly wealthy.

The problem I have with these comparisons is that GDP is but one indicator of success. We can measure GDP statistically, but it does not include cultural biases. For example, while my wife could choose to work, she does not work right now. We felt it was important to raise our children with at least one parent at home. Now that the kids are grown, she is considering going back to work. That is our family's cultural bias which happens to be the bias of many of the people who work in my company. Even though population has grown in the US over my lifetime, I am finding more and more people are choosing not to work because they do not have to. To me that is success. However as fewer people who can work choose not to work we are reducing the need for services for people who work (fewer people commuting means lower vehicle usage, fewer business lunches, etc.) and therefore the economy can shrink while at the same time this particular definition of success increases.

[k579] Between 1981 and 1989 the Mexican economy had grown at an annual rate of only 1.3 percent, well short of population growth, leaving per capita income far below its 1981 peak. From 1990 to 1994, the years of the "Mexican miracle," things were definitely better: the economy grew 2.8 percent per year. But this was still barely ahead of population growth; as of 1994 Mexico was still, according to its own statistics, far below its 1981 level. Where was the miracle--indeed,

[k618] What is supposed to happen when a country's currency is devalued is that speculators say, "Okay, that's over," and stop betting on the currency's continued decline. That's the way it worked for Britain and Sweden in 1992. The danger is that speculators will instead view the first devaluation as a sign of more to come, and start speculating all the harder. In order to avoid that, a government is supposed to follow certain rules. First, if you devalue at all, make the devaluation big enough. Otherwise, you will simply set up expectations of more to come. Second, immediately following the devaluation, you must give every signal you can that everything is under control, that you are responsible people who understand the importance of treating investors right, and so on. Otherwise the devaluation can crystallize doubts about your economy's soundness and start a panic.

In my experience there is a big difference between investors and ForEx traders. Buffet is an investor and Soros is a trader. The reason for a swift drop in a currency's price has nothing to do with investors and everything to do with traders. See my Objectively Rich for more info.

[k627] Worse yet, it soon became clear that some Mexican businessmen had been consulted about the devaluation in advance, giving them inside information denied to foreign investors. Massive capital flight was now inevitable, and the Mexican government soon had to abandon fixing the exchange rate at all. Still, Serra Puche was quickly replaced, and Mexico began making all the right noises. And one might have thought that all the reforms since 1985 would count for something. But no: foreign investors were shocked--shocked!--to discover that Mexico was not the paragon it had seemed, and wanted out at any cost. Soon the peso had fallen to half its pre-crisis value.

This is where Keynes's animal spirits are crucial to accept. Buffet treats such panics as investment opportunities. This is where the investors are separated from the traders. However, to be an investor you have to have built up reserves for that rainy day when investment opportunities present themselves. Unfortunately this means you must be extremely disciplined and patient. You have to aim for 10 years out or more. You do not know what will be happening in 10 years, but you do know some opportunity will present itself, and you will have the capital to seize it. Note that capital does not have to mean cash or equivalents. It might mean an organization primed for an opportunity which it can handle.

[k649] Perhaps Argentina was attacked because to Yanqui investors all Latin American nations look alike. But once speculation against the Argentine peso began, it became clear that the currency board did not provide the kind of insulation its creators had hoped for. True,

[k712] What we should have asked was the question posed in many meetings by the economist Guillermo Calvo, of the World Bank and later of the University of Maryland: "Why was so large a punishment imposed for so small a crime?" In the aftermath of the tequila crisis it was all too easy to revisit the policies followed by Mexico in the run-up to that crisis, and find them full of error. But the fact was that at the time they seemed pretty good, and even after the fact it was hard to find any missteps large enough to justify the economic catastrophe of 1995.

[k717] We should have looked more closely at the arguments of some commentators that there really were no serious mistakes at all, except for the brief series of fumbles that got Mexico on the wrong side of market perceptions and set in motion a process of self-justifying panic. And we should therefore also have realized that what happened to Mexico could happen elsewhere: that the seeming success of an economy, the admiration of markets and media for its managers, was no guarantee that the economy was immune to sudden financial crisis.

[k728] Perhaps most of all, we failed to understand the extent to which both Mexico and Washington simply got lucky. The rescue wasn't really a well-considered plan that addressed the essence of the crisis: it was an emergency injection of cash to a beleaguered government, which did its part by adopting painful measures less because they were clearly related to the economic problems than because by demonstrating the government's seriousness they might restore market confidence. They succeeded, albeit only after the economy had been punished severely, but there was no good reason to suppose that such a strategy would work the next time.

[k802] At the beginning of 1990 the market capitalization of Japan--the total value of all the stocks of all the nation's companies--was larger than that of the United States, which had twice Japan's population and more than twice its gross domestic product.

[k806] The late 1980s represented a time of prosperity for Japan, of fast growth, low unemployment, and high profits. Nonetheless, nothing in the underlying economic data justified the tripling of both land and stock prices during that period. Even at the time many observers thought that there was something manic and irrational about the financial boom--that traditional companies in slowly growing industries should not be valued like growth stocks, with price-earnings ratios of 60 or more. But as is so often the case in manic markets, the skeptics were without the resources, or the courage, to back their lack of conviction; conventional wisdom found all sorts of justifications for the sky-high prices.

[k849] Modern nations, even if they do not explicitly guarantee deposits, cannot find it in their hearts to let widows and orphans lose their life savings simply because they put them in the wrong bank, just as they cannot bring themselves to stand aside when the raging river sweeps away houses foolishly built in the flood plain. Only the most hard-nosed of conservatives would wish it otherwise. But the result is that people are careless about where they build their houses, and even more careless about where they store their money.

[k953] The Great Depression in the United States was brought to an end by a massive deficit-financed public works program, known as World War II.

[k1184] Sometimes a panic is just a panic: an irrational reaction on the part of investors that is not justified by the actual news. An example might be the brief plunge in the dollar in 1981, after a deranged gunman wounded Ronald Reagan.

[k1188] Much more important in economics, however, are panics that, whatever sets them off, validate themselves--because the panic itself makes panic justified. The classic example is a bank run: when all of a bank's depositors try to withdraw their money at once, the bank is forced to sell its assets at distress prices, causing it to go bankrupt; those depositors who did not panic end up worse off than those who did.

Given the speed with the Thai crisis spread it is likely that the problems were caused by speculation more than anything else. I don't buy the argument that it was "other companies" at all. Just like in the US in the current crisis, financial institutions overextended themselves with high risk investments.

[k1198] Unfortunately, both the decline in the currency's value and the rise in interest rates created financial problems for businesses, both financial institutions and other companies. On one side, many of them had dollar debts, which suddenly became more burdensome as the number of baht per dollar increased; on the other, many of them also had baht debts, which became harder to service as interest rates soared.

[k1412] What the story of the globo and its demise tells us is that countries cannot get all three wishes; at most, they can get two. They can give up on exchange rate stability; this means adopting a floating exchange rate, like the United States and Australia did. They can give up on discretionary monetary policy; this means fixing the exchange rate, the way Argentina did in the 1990s, and possibly even giving up their own currency, like the nations of continental Europe did. Or they can give up on the principle of completely free markets and impose capital controls; this was what most countries did between the 1940s and the 1960s, and what China does right now.

We live in an age which amplifies the herd and hence speculation can be extremely profitable as Soros has shown. It is not that Soros is genius rather the particular herd psychology of his time is matched to his psychology. Plenty of fallen stars demonstrate times change and Soros is left standing as a survivor. Unfortunately unlike in biology Soros is not replicating. Whatever his organization does is unique and it has to be this way or the Soros strategy would fail due to the nature of the closed system of markets.

[k1470] The funny thing is that once you take the possibility of self-fulfilling crises seriously, market psychology becomes crucial--so crucial that within limits, the expectations, even the prejudices of investors, become economic fundamentals--because believing makes it so.

[k1602] Hedge funds with good reputations have been able to take positions as much as a hundred times as large as their owners' capital; that means that a 1 percent rise in the price of their assets, or decline in the price of their liabilities, doubles that capital. The downside, of course, is that a hedge fund can also lose money very efficiently.

[k1635] It worked. Soros's high-profile assault on the pound began in August. Within weeks Britain had spent nearly $50 billion in the foreign exchange markets to defend the pound, to no avail. In mid-September the government raised interest rates to defend the currency, but this proved politically unacceptable. After only three days Britain dropped out of the ERM, and the pound was set afloat (where it remains to this day). Soros not only made roughly a billion dollars in quick capital gains but also established himself as perhaps the most famous speculator of all time.

[k1646] Finally, did Soros do his victims any harm? The government of Prime Minister John Major never recovered from the humiliation. But it is actually possible to argue that Soros did the British nation as a whole a favor.

[k1675] Nonetheless, Mahathir clearly should have kept his mouth shut. At a time when confidence in his economy was already plunging, the sight of the prime minister raving about an American conspiracy against Asia--and broadly hinting that it was in fact, yes, a Jewish conspiracy--was not what the money doctors would have prescribed.

[k1836] It is important to realize that even now Fed officials are not quite sure how they pulled this rescue off. At the height of the crisis it seemed entirely possible that cutting interest rates would be entirely ineffectual--after all, if nobody can borrow, what difference does it make what the price would be if they could? And if everyone had believed that the world was coming to an end, their panic might--as in so many other countries--have ended up being a self-fulfilling prophecy. In retrospect Greenspan seemed to have been like a general who rides out in front of his demoralized army, waves his sword and shouts encouragement, and somehow turns the tide of battle: well done, but not something you would want to count on working next time.

[k1850] When Greenspan left office, he did so trailing clouds of glory. Alan Blinder of Princeton University pronounced him possibly the greatest central banker in history. When Greenspan made one of his final appearances before Congress, he was hailed virtually as a monetary messiah: "You have guided monetary policy through stock-market crashes, wars, terrorist attacks and natural disasters," declared one congressman. "You have made a great contribution to the prosperity of the U.S. and the nation is in your debt." Almost three years later, Greenspan's name was mud.

[k2141] The financial crisis has, inevitably, led to a hunt for villains. Some of the accusations are entirely spurious, like the claim, popular on the right, that all our problems were caused by the Community Reinvestment Act, which supposedly forced banks to lend to minority home buyers who then defaulted on their mortgages; in fact, the act was passed in 1977, which makes it hard to see how it can be blamed for a crisis that didn't happen until three decades later. Anyway, the act applied only to depository banks, which accounted for a small fraction of the bad loans during the housing bubble.

[k2155] Yet the crisis, for the most part, hasn't involved problems with deregulated institutions that took new risks. Instead, it has involved risks taken by institutions that were never regulated in the first place. And that, I'd argue, is the core of what happened. As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that we were re-creating the kind of financial vulnerability that made the Great Depression possible--and they should have responded by extending regulation and the financial safety net to cover these new institutions.

[k2167] Meanwhile, the people who should have been worrying about the fragility of the system were, instead, singing the praises of "financial innovation." "Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors," declared Alan Greenspan in 2004, "but also the financial system as a whole has become more resilient."

[k2498] We have magneto trouble, said John Maynard Keynes at the start of the Great Depression: most of the economic engine was in good shape, but a crucial component, the financial system, wasn't working. He also said this: "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." Both statements are as true now as they were then.

What we need is verification which identifies all large capital flows within companies. The cost of verification is tiny in comparison to the cost of bailouts. In software we have learned that dynamic systems need executable assertions. The same is true for dynamic financial systems. The larger the capital and the faster it flows, the greater the risk.

[k2509] I won't try to lay out the details of a new regulatory regime, but the basic principle should be clear: anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated when there isn't a crisis so that it doesn't take excessive risks. Since the 1930s commercial banks have been required to have adequate capital, hold reserves of liquid assets that can be quickly converted into cash, and limit the types of investments they make, all in return for federal guarantees when things go wrong. Now that we've seen a wide range of non-bank institutions create what amounts to a banking crisis, comparable regulation has to be extended to a much larger part of the system.

Via Rob 04/20/2009