The Return of Depression Economics

Paul Krugman, “The Return of Depression Economics” (And The Crisis of 2008), W.W. Norton & Co, 2009
The book is well worth reading: It is written in a style that is easily comprehended; it provides a good synopsis of the financial and economic disruptions around the world over the past twenty years; another must read.

Paul Krugman is the recipient of the 2008 Nobel Prize in Economics. He teaches economics and international affairs at Princeton University & writes a twice-weekly column op-ed page for the New York Times.

This book is a second edition work. The first edition was written in response to the Asian Crisis; the second edition updates and adds material to the various disruptions of the 1990s attempting to explain how the United States evolved into the current crisis it now faces in 2008.

It is worth reviewing the Asian crisis because it “turns out to have been a sort of rehearsal for the global crisis now in progress.” There are five basic proposals that Krugman presents, all of them fitting into what the author refers to as the “Keynesian Compact”, a consensus achieved in the 1950s among most economists, otherwise referred to as the “neoclassical consensus.” His five proposals are:
• Put more capital into the banking system to help unfreeze capital markets, with more government control—in effect, it will come closer to a full temporary nationalization of a significant part of the financial system.
• Create a lending program for the government to lend to the nonfinancial sector;
• Engage in a global rescue program for developing countries;
• Fiscal stimulus focusing on spending to build infrastructure, etc.;
• Reform and regulate the financial system, especially the non-bank areas.
It is surprising that Krugman makes no mention that the value of the United States dollar declined by about 40% from 2002 to the Summer of 2008 and the role the Fed played in this decline.

In the policy realm, Krugman argues that macroeconomic managers — economic policymakers — want three things:
* Discretion in monetary policy so they can fight recessions and curb inflation.
• stable exchange rates so that businesses are not faced with too much uncertainty;
• free international trade.

He concludes that a country can only achieve two of these…it is impossible to achieve all three at the same time. Countries can give up on exchange rate stability; this means adopting a floating exchange rate, like the U.S. and Australia did. They can give up on discretionary monetary policy; this means fixing the exchange rate, the way Argentina did in the 1990s when they pegged their currency to the dollar, 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.

Notes:

Pg. 57: Japan spent most of the 1990’s in a slump, alternating brief periods of economic growth with ever-deeper recessions. Japanese industry in 1998 produced less than it had in 1991. If it could happen to the Japanese, who was to say that it couldn’t happen to us? And sure enough, it did.

Pg. 61: 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 U.S., which had twice Japan’s population and more than twice its gross domestic product. Land, never cheap in crowded Japan, had become incredibly expensive: according to a widely cited factoid, the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California. Welcome to the bubble economy.

The late 1980’s 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. But as is so often the case in manic markets, conventional wisdom found all sorts of justifications for the sky-high prices.

Pg. 66: Unlike Mexico in 1995, South Korea in 1998, and Argentina in 2002, Japan never went through a year of unmistakable, catastrophic economic decline. In the decade after the bubble burst, Japan experienced only two years in which real GDP actually fell. However Japan was in a liquidity crisis as we are now in.
Liquidity Crisis Cures require:
• Near to zero interest rates
• Deficit spending (preferably upgrade the infrastructure)
• Pump up the banks
• Inflation (people will invest if the erosion effects of inflation frightens them)

Pg. 120: Hedge funds don’t hedge. What hedge funds do is to try to make the most of market fluctuations. The way they do this is typically to go short in some assets and long in others. Profits come if the price of the shorted asset falls or the value of the purchased asset rises, or both. The advantage of this kind of financial play is that it can deliver a very high return to the hedge funds’ investors. The reason is that the fund can take a position much larger than the amount of money its owners put in, since it buys its “long” position mainly with the cash raised from creating its “short” position. Indeed, the only reason it needs to have any capital at all is to persuade the counterparties to its asset shorts that it will be able to deliver on its promises. Hedge funds with good reputations have been able to take positions as much as a hundred times as large as their owner’s 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.

Pg. 149: Collateralized Debt Obligation (CDO): The financial innovation that made securitization of subprime mortgages possible was the CDO. A CDO offered shares in the payments from a mortgage pool—but not all shares were created equal. Instead, some shares were “senior”, receiving first claim on the payments from the mortgagees. Only once those claims were satisfied was money sent to less senior shares. In principle, this was supposed to make the senior shares a very safe investment; even if some mortgages defaulted, how likely was it that enough would default to pose problems for the cash flow to these senior shares? So the rating agencies were willing to classify senior shares in CDOs as AAA even if the underlying mortgages were highly dubious. Now many institutional investors, such as pension funds, that won’t buy anything except AAA securities but were quite willing to buy AAA-rated assets that yielded significantly higher returns than ordinary bonds. As long as housing prices kept rising, everything looked fine and the Ponzi scheme kept rolling.

Pg. 158: The Shadow Banking System: probably the best way to describe these are through the following example, an arrangement known as an auction-rate-security, which was invented at Lehman Brothers in 1984 and became a preferred source of funding for many institutions. The arrangement worked like this: Individuals would lend money to the borrowing institution on a long-term basis; legally, the money might be tied up for thirty years. At frequent intervals, however, often once a week, the institution would hold a small auction in which potential new investors would bid for the right to replace investors who wanted to get out. The interest rate determined by this bidding process would apply to all funds invested in the security until the next auction was held, and so on. If the auction failed—if there weren’t enough bidders to let everyone who wanted out to leave—the interest rate would rise to a penalty rate, say 15 percent; but that wasn’t expected to happen. The idea of an auction-rate security was that it would reconcile the desire of borrowers for secure long-term funding with the desire of lenders for ready access to their money.
By keeping this entire system out of the regulated banking system, they had less expenses and could pay more and borrow at lower rates. Also, banks are required to hold liquid reserves, maintain substantial capital, and pay into the deposit insurance system.

And sure enough, the auction-rate security system, which contained $400 billion at its peak, collapsed in early 2008 as too few new investors arrived to let existing investors get their money out. People who thought they could have ready access to their money were instead tied up in decades-long investments they could not get out of.
The parallel to the Panic of 1907 should be obvious. In the early years of the twentieth century, the trusts, the bank-like institutions that seemed to offer a better deal because they were able to operate outside the regulatory system, grew rapidly, only to become the epicenter of a financial crisis. A century later, the same thing happened.

Pg. 165: This crisis is like everything we’ve seen before, all at once: a bursting real estate bubble comparable to what happened in Japan at the end of the 1980s; a wave of bank runs comparable to those of the early 1930s (albeit mainly involving the shadow banking system rather than conventional banks); a liquidity trap in the U.S., again reminiscent of Japan; and, most recently, a disruption of international capital flows and a wave of currency crises all to reminiscent of what happened to Asia in the late 1990s.

Pg. 168: Eventually it became clear that nothing related to housing was safe—not senior shares in CDOs, not even loans made to borrowers with good credit ratings who made substantial down payments. This was because of the sheer scale of the housing bubble. Nationally housing was probably overvalued by more than 50 percent by the summer of 2006, which meant that to eliminate the overvaluation, prices would have to fall by a third. In some areas like Miami prices could be expected to fall by 50 percent or more. With mortgages worth more than the house, people will walk away, and are. There are probably 12 million American homeowners with negative equity at the end of 2008.