"The Return of Depression Economics"

Brad DeLong reviews the second edition of Krugman's "The Return of Depression Economics":

'The Return of Depression Economics and the Crisis of 2008,' by Paul Krugman, Book Review by Brad DeLong., LA Times: A decade ago, Paul Krugman wrote a little book warning us that economists' triumphalism was misplaced -- that advances in economic knowledge ... had not, after all, banished the prospect of big depressions from the global economy. "The Return of Depression Economics" sank with barely a ripple. ...

Now Krugman is back ... with ... a second edition in "The Return of Depression Economics and the Crisis of 2008."... His thesis makes me want to say "no" and "yes." No, Krugman is wrong when he worries that the disease of the business cycle "long . . . considered conquered . . . had reemerged in a form resistant to all the standard" remedies. The standard remedies still do work. Yes, he is right in his claim that "depression economics" is very relevant to economic discourse and policymaking today...

If liquidity is king What is "depression economics"? ...The capital stock of our economy ... consists of the semiconductor fabrication facilities of Applied Materials, the patents of Merck, the roadbed of CSX -- not at all the kind of things that command money on short notice in the consumer marketplace.

Now what happens when everybody -- or a small but coordinated subset of everybodies -- decides that they want liquidity (their money now...) or safety...?

In normal times, when one investor wants more liquidity or safety, another will be willing to take on duration and risk, and they will simply swap portfolios at current market prices. But in abnormal times, they cannot: The semiconductor fabs are long-run, durable, risky assets that cannot practically be liquidated. And so when the everybodies all decide that they want liquidity and safety -- well, the economy cannot magically liquidate the fixed capital stock at a reasonable price. And to liquidate at falling prices creates mass unemployment. This is the key to "depression economics." And this is why the industrial business cycle emerged as a disease of the Industrial Revolution.

'Obvious solution'  Here, Krugman backs off his musings about how this time the disease might be more virulent and antibiotic-resistant, for he proposes none other than the standard remedies. He calls for ... injections of capital into the banking system, Keynesian government spending. He notes that this solution is now underway -- although delayed for a long time, perhaps too long for our good, by the Bush administration's ideological blinkers.

If the everybodies want liquidity in their portfolios but the private market cannot turn durable capital into directly useful cash, Krugman argues, the government should step in and do so: It should directly or indirectly buy the long-term bonds that underpin our social investments in exchange for cash that it prints up fresh for the occasion. A confidence trick? Yes. A potential source of inflation? Possibly. But it works.

And if the government then finds that the everybodies are still not happy with their portfolios because they want not just short-duration liquid assets but safe ones as well, then the government needs to ... assume partial or complete ownership of risky banks and portfolios...

Others have done it As Krugman writes, we know how to do this: Sweden did it in the early 1990s... And as a next step, Krugman recommends a "good old Keynesian fiscal stimulus"...

And, when push comes to shove, Krugman believes that we do understand how to vaccinate the system against at least the most virulent strains of the disease. It is fine for banks and other financial institutions to promise their depositors and investors that their money is liquid and safe though it is in fact invested in the durable and risky capital of the economy: That is what banks do. The danger comes when they do it too much: promise too much liquidity and too much safety. The answer has been clear for a century: Rein them in. Krugman's principle is: "[A]nything that . . . plays an essential role in the financial mechanism should be regulated ... so that it doesn't take excessive risks"...

The ... problem this time is that we did not understand the degree to which all the mortgage finance companies, investment conduits, MBS vehicles, CDO tranches, monolines and other non-bank financial players that had taken on the role of banks -- of making long-term durable risky investments yet promising those who contributed the funds that their funds were liquid and safe -- without being regulated like banks.

We won't make this mistake again. At least not for a generation.

Comments

[Patricia Shannon]

We won't make this mistake again. At least not for a generation.
Too true.
We humans have been so successfully in the relatively short time we have existed, in part because of our tendency to risk-taking.
But the same tendency may very well lead to our extinction, if the rest of life on this planet is lucky, and certainly to severe problems.

[mmckinl]

Wrong, wrong, wrong ...

What we have is a debt bubble bursting, not just the housing bubble but debt in many sectors.

The U.S. has been on a debt binge for over 25 years and now has an aggregate debt of over 50 trillion dollars. This debt iss over 3.5 times the GDP, a level three times the debt level of the stock market bust and twice the level of the deepest part of the Depression.

There is only one way to get through this, start writing down debt. How do we do this and not crash the economy? We do what Lincoln did to fund the Civil War, Print Money.

As long as the deflation goes on the printed money will counterbalance the loss of money maintaining liquidity in the system. The printed money would be used to capitalize solvent banks and monetize the credit system.

Once inflation starts rearing its head deposits are withdrawn gradually while raising income taxes on the well to do damps demand.

says...

I've given up on Brad DeLong. Any fool that says use tax payer money to buy stock is just that ... a fool.

[anne]

http://dinersjournal.blogs.nytimes.com/2008/12/01/copia-files-for-chapter-11/?hp

December 1, 2008

Wine Museum Files for Chapter 11
By JULIA MOSKIN

Copia, the ambitious food, wine, and art museum in Napa, Calif., filed for bankruptcy protection on Monday.

[OMG! What does this mean, back to Thunderbird? What is Thunderbird, anyway?]

[ken melvin]

"What's the word?
Thunderbird.
What's the price?
Thirty twice."

"Twas Thunderbird that built the Gallo Empire. Whence Thunderbird their respectability.

[Beezer]

I knew Thunderbird and Pabst Blue Ribbon personally. I think I'm in love with Anne. Or at least her posts.

As for central banks buying stock. Hong Kong's monetary authrity turned a $14 billion profit after the 1988-89 crisis by doing just that.

[Beezer]

Sorry. 1997-99 crisis.

[ctindale]

Folks should get really focussed on debt and its role in economic expansion. Delong and Krugman take us away from capitalism and take us toward a new "ism" maybe "regulatorism", this is where the economy is centrally planned through mangement of consumption, the problem is there is not a single person on this blog who can explain what to do with long run debt and /or currency problems that are an outcome of the Krugman/Delong solutions.

Eventually there is a reckoning and the scam is unwrapped at some future point, yet we have our so called leading economists pushing forward with this devils pact.

Why not you just abort all our children now and save them the misery of what we bequeath them.

[Hank Roberts]

Remember "What if the Boomers Can't Retire?" of a few years ago?

http://books.google.com/books?id=6j0CVZIE8bgC&dq=What+if+boomers+can%27t+retire&pg=PP1&ots=ybKLXZA8gv&source=bn&sig=Z2XSA3SGW6NFPF3Saep1ezoO1Oc&hl=en&sa=X&oi=book_result&resnum=4&ct=result

says...

"[OMG! What does this mean, back to Thunderbird? What is Thunderbird, anyway?]"

We cannot afford to keep thinking outside the box. Not for another generation.

[ndk]

Uh-oh. Others are starting to sniff out that this might not be a liquidity trap after all.

If the answer is that banks do not have money to lend, it would make sense to push capital into their hands, as the Treasury has been doing over the last two months, she continued. But if the answer is that their potential borrowers are getting less creditworthy with each passing day, “pouring money into banks isn’t going to fix that problem,” she said.

Welcome to the solvency trap, Treasury. We've been waiting for you to join us here.

[ndk]

By the way, market data today was terrible, far beyond stocks alone. The CP market collapsed by another 200 bp's to cycle wide spreads, despite the Fed already owning ~20% of the outstanding paper. Across the Curve has the details on the "impolite bludgeoning" in the mortgage derivatives today.

I can't believe the CP market is basically shut down. Surreal. This stuff's been around for 200 years, with only a couple known defaults.

I really, really wish the Fed and Treasury hadn't already swallowed so much bad water...

[Too Much Fed]

"We won't make this mistake again. At least not for a generation."

Patricia Shannon, it takes about 2 generations for another debt bubble to build.

See this link and the charts (notice the dates):

http://www.prudentbear.com/index.php/commentary/guestcommentary?art_id=10141

[Too Much Fed]

mmckinl said: "What we have is a debt bubble bursting, not just the housing bubble but debt in many sectors.

The U.S. has been on a debt binge for over 25 years and now has an aggregate debt of over 50 trillion dollars."

OK and was this greenspan's plan all along???

"There is only one way to get through this, start writing down debt."

Does that mean pay the debt down, default on the debt, or some combination?

"As long as the [price] deflation goes on the printed money will counterbalance the loss of money maintaining liquidity in the system. The printed money would be used to capitalize solvent banks and monetize the credit system."

I believe it is the lower and middle class that needs recapitalized NOT the banks. Wouldn't paying back more of the debt "recapitalize" the banks and help the credit system?

"Once [price] inflation starts rearing its head deposits are withdrawn gradually while raising income taxes on the well to do damps demand."

OK.

[ndk]

Does that mean pay the debt down, default on the debt, or some combination?

Writing down is reducing the principal owed. It generally doesn't count as paying it down nor defaulting on it. I think mmckinl's plan for resolution is a lot like mine.

[paine]

brightly fatuous brad strikes again

note this:

if there's money to be made...big money
evading regulations
then the great escape will be plotted planed and executed
with or withour wall guard of the moment complicity

sounds like the source of these crises
may lie beyond the institutional
and in system's "deep structure" to me

free ranged for ever
or shackled ..for now
private profit guided
corporate capitalism makes these buggars inevitable
some day some how and....
with a vengence

[paine]

on the what works front

krug in the first edition was trying to release policy wonks from the spell of pure credit policy macro management
an auto imune disease contracted by keynesian neoclassical
synthetics ..in the high ho stagflation 70's

paul declares
a new era
where deficit spending is king again

the return of deficit spending
to its heroic roles in macro management
this brad would for whatever reason---perhaps his
on all fours
support of the old cyclops methods
of feldtstein et al
and as a pulling guard leading the rush here
he made himself obvious
as neoliberal down field blocker

[paine]

the diff between ye olde brad the benign
and say... a mankiw shark??

generous pro people elastcity assumptions
not enough to save his soul i dare say

so is a new brad slowly unwrapping
himself like salome
viewable now at his blog near you ???

[anne]

During the Asian currency crisis, Hong Kong bought shares in the island's stock index much to the dismay of Milton Friedman who wished what was always a fiction of no interference in the economy by government to be maintained. Hong Kong had however always interfered in the island's economy, and during the currency crisis from 1997 to 1999 there was a danger of credit flows away from Asian economies. Since the Hong Kong Dollar is tied to the American dollar, a flow of credit from the island would mean an automatic interest rate increase to protect the Dollar tie. An increase in interest rates during what were a series of recessions in Asian economies would further deepen a recession. So Hong Kong chose to but the island's stock index, using this as a means of bolstering credit and avoiding an interest rate increase.

The Hong Kong stock buying strategy worked as intended, but has nothing to do with America buying the country's stock index since falling stock prices are not a problem causing us to have to raise interest rates. The idea of the government buying American stocks to raise prices is quite strange since there is no reason to believe stocks are being artificially priced internationally.

[anne]

http://www.nytimes.com/2008/12/02/business/economy/02econ.html?hp=&pagewanted=print

December 2, 2008

Officials Vow to Act Amid Signs of Long Recession
By EDMUND L. ANDREWS

With word that the U.S. officially sank into a recession last December, the Fed chairman and the Treasury secretary said they would use all the tools at their disposal.

[Notice the wording.]

[anne]

What is shameful about a prestigious committee of economists taking a year to decide that the economy has been in a recession for a year, especially when the recession is not being purposely produced by the Federal Reserve to limit excessive growth or inflation but is an out of control deterioration of conditions threatening any number of middle and lower income people, what is shameful is that the committee could have far earlier focused attention on the need for concerted efforts to limit the recession.

The NBER committee has obviously acted politically and shamefully.

[anne]

Though the conditions for ordinary workers were suspect all through the economic expansion from 2001, and though there was a marked deterioration in the already tepid labor market from early in 2007, though there had been an easily evident and growing housing crisis since the middle of 2005, when a writer in the New York Times wrote in November 2007 * that when it feels as though there is a recession there might well be a recession, a supposedly liberal significantly influential economist immediately and personally demeaned the writer. **

Of course November 2007, we understand in December 2008, was the eve of the formal recession. The lesson however was there for all. Dare to question what might be a recession, and when there might be a recession, for the sake of protecting obviously hurting people, and risk being violently insulted.

* http://www.nytimes.com/2007/11/10/opinion/10herbert.html

**
http://delong.typepad.com/sdj/2007/11/can-we-retire-b.html

[anne]

Then too, another supposedly liberal economist of significant influence * had earlier in 2007 after there could be no doubt that there was already housing crisis in communities with relatively less wealthy homeowners, especially in communities of African Americans and Latinos and older homeowners, and the crisis was quickly and inevitably spreading, had laughingly dismissed the notion of there being a problem let alone a crisis, as though loss of a home were as nothing and loss of a community were laughable.

Through a period, then, when there was need to recognize and act on a serious and growing set of economic problems, economists who are inevitably political creatures as are all social scientists, were undermining focus on the problems and the absurd slowness of the NBER to alert us to being in a recession this time should not be ignored.

* http://www.nytimes.com/2007/03/29/business/29scene.html

[Massimo GIANNINI]

Philosophers or economists? They puzzles

[anne]

Be reassured, for the 3 month Treasury interest rate is now at 0.2% rather than 0.1%, though the 2 year Treasury is 0.89%. The 10 year Treasury is 2.71%, while an A1 rated portfolio of intermediate term bonds is yielding 7.58% at Vanguard. These are Depression-like numbers, not that there should be a comparison.

[anne]

http://www.nytimes.com/2008/12/03/business/worldbusiness/03yen.html?ref=business&pagewanted=print

December 3, 2008

Japan Acts to Ease Crisis in Corporate Credit
By MARTIN FACKLER

The Bank of Japan announced emergency measures to ease an acute squeeze in corporate funding that threatens to push Asia’s largest economy deeper into recession.

[Even more cause for be reassured.]

[Trust]

"The ... problem this time is that we did not understand the degree to which all the mortgage finance companies, investment conduits, MBS vehicles, CDO tranches, monolines and other non-bank financial players that had taken on the role of banks..."

No need to worry, as no one trusts these alphabet soup institutions enough to do business with them again. We are back to the standard insured deposit banking model, only this time with insured deposits that are only a small fraction of the amount needed to meet domestic credit demand.

[anne]

http://www.nytimes.com/2008/12/02/opinion/02herbert.html?ref=opinion

December 2, 2008

A Team of Whizzes
By BOB HERBERT

Barack Obama appears to have put together an extraordinarily competent team to cope with the crises abroad and at home — and to begin cleaning up the mess of the past eight years.

So why do I have this uneasy feeling?

[Interesting, the day after we learn officially that there is a recession, the same writer who was worried about a recession a year ago on the verge of actual recession, worried because of the effects of evident economic deterioration on those who are not rich and those who do not have the ear of power, the same writer who was told by an influential supposedly liberal economist to retire and do something socially useful is worried still.]

[anne]

http://www.nytimes.com/2008/12/02/opinion/02herbert.html?ref=opinion

December 2, 2008

A Team of Whizzes
By BOB HERBERT

Will this new Obama team, as brilliant as it appears to be, begin addressing on day one the interests of those who are not rich and who have not had the ear of those in power?

[Possibly, since we officially know there is a recession a writer can be allowed to write in such a vein even as a non-official-economical-writer.]

[anne]

http://www.latimes.com/entertainment/la-et-book1-2008dec01,0,364672,print.story

December 1, 2008

Nobel Prize Winner Paul Krugman Presents a Strong Argument -- Financial Bailout and All
By Brad DeLong - Los Angeles Times

And the problem this time is that we did not understand the degree to which all the mortgage finance companies, investment conduits, MBS vehicles, CDO tranches, monolines and other non-bank financial players that had taken on the role of banks -- of making long-term durable risky investments yet promising those who contributed the funds that their funds were liquid and safe -- without being regulated like banks....

[Of course, we did know, we knew well enough about the emergence of an increasingly influential shadow banking system that the New York Times could discuss hedge fund money being raised expressly to invest against corporations undermining themselves by becoming mortgage bankers and holding ever more risky mortgage debt and debt derivatives. Was anyone reading beyond Paul Krugman? Yes.]

[anne]

"And the problem this time is that we did not understand...."

But, who is this we who did not understand what? Explain and justify this or the comment is mere self-serving nonsense. Goldman Sachs executives understood enough to rid the company of mortgage or mortgage-backed debt even as Goldman happily continued to package and sell such debt. (I wonder if the clients understand even now that Goldman knew.) There were repeated warnings about housing and excessively expensive mortgages and mortgage-backed derivatives for years. Who did not know, then? Who is this "we?"

[anne]

"And the problem this time is that we did not understand...."

http://www.nytimes.com/2007/08/19/business/19credit.html?hp

August 19, 2007

How Missed Signs Contributed to a Mortgage Meltdown
By NELSON D. SCHWARTZ and VIKAS BAJAJ

All through last year, Jim Melcher saw the signs of a rapidly deteriorating American housing market — riskier mortgages, rising delinquencies and more homes falling into foreclosure. And with $100 million in assets at his hedge fund, Balestra Capital, he was in a position to do something about it.

So in October, as mortgage-backed bonds were still flying high, he bet $10 million that these bonds would plunge in value, using complex derivatives available to any institutional investor. As his gamble began to pay off in the first months of 2007, Mr. Melcher, a money manager based in New York, plowed the profits into ever bigger wagers that the mortgage crisis would worsen further, eventually risking some $60 million of the fund's money.

"We saw the opportunity of a lifetime, and since then events have unfolded on schedule," he said. Mr. Melcher's flagship fund has since doubled in value, even as this summer's market turmoil cost other investors billions, forced the closing of several major hedge funds and pushed the stock market down 7 percent since mid-July. This week, Mr. Melcher is heading to Paris for a vacation with his wife.

The extent of the turmoil has stunned much of Wall Street, but as Mr. Melcher's case makes clear, there were ample warning signs that a financial time bomb in the form of subprime mortgages was ticking quietly for months, if not years.

As far back as 2001, advocates for low-income homeowners had argued that mortgage providers were making loans to borrowers without regard to their ability to repay. Many could not even scrape together the money for a down payment and were being approved with little or no documentation of their income or assets.

In December, the first subprime lenders started failing as more borrowers began falling behind on payments, often shortly after they received the loans. And in February, HSBC, the large British bank, set aside $1.76 billion because of problems in its American subprime lending business.

Over the last two weeks, this slowly building wave became a tsunami in the global financial markets....

[anne]

There is understanding and there is willful not understanding....

http://www.nytimes.com/2007/03/29/business/29scene.html?ex=1332820800&en=9a15c212b118d691&ei=5090&partner=rssuserland&emc=rss

March 29, 2007

'Irresponsible' Mortgages Have Opened Doors to Many of the Excluded
By AUSTAN GOOLSBEE

Almost every new form of mortgage lending — from adjustable-rate mortgages to home equity lines of credit to no-money-down mortgages — has tended to expand the pool of people who qualify but has also been greeted by a large number of people saying that it harms consumers and will fool people into thinking they can afford homes that they cannot....

For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage.

Austan Goolsbee is a professor of economics at the University of Chicago Graduate School of Business.

[What is the Long Term Plan?]

"...had taken on the role of banks..."

They did not understand that the traditional insured deposit banking system had lost its ability to meet domestic credit demand. Now they do, but they still don't understand how policy had systematically eliminated the banking system's ability to meet domestic credit demand. The ad hoc system that replaced it was dysfunctional, and is now destroyed. Overseas central banks are systematically purging all loans to the US private sector from their countries. The Fed/Treasury first attempted to temporarily replace the lost private sector credit by public borrowing, and re-loaning to the private sector. Loans of forced savings are now supplementing this.

There is no long term plan to set up a sustainable system. Just temporary emergency measures. Now a plan to regulate the already broken (thus useless) ad hoc system that replaced the traditional banking model. Regulating a system that no longer functions won't restore circular flow. How can regulating non GSE mortgage originators restore flow, when there are virtually no non GSE mortgage originators left?

By all means regulate them so they can't ever do this again. However, we need a long term plan to set up a sustainable system of circular flow. Waiting around for another ad hoc system to develop on its own is not a good plan.

[anne]

"Overseas central banks are systematically purging all loans to the US private sector from their countries."

Where is the reference? Where is the precise reference? I know of nothing whatsoever that will support this, but surprise me.

[Patricia Shannon]

Anne, not long ago when I predicted that stock prices would decline when baby boomers started to retire and started selling off their stock to live on, I believe you castigated me with "lies, lies, lies".

[anne]

"I believe you castigated me...."

I am entirely sure you are wrong about what I supposedly wrote, of course, but do please show me a link to prove otherwise. Predicting what stocks will or will not do when a person retires, or many persons retire, means nothing to me and has no interest to me and is only suppositional.

[Icarus]

The current crisis, shows, among many things, that it is the middle class US consumer who is no longer as credit worthy as the reckless financing of the past few years implied.

We have high school graduates, with almost no skills, expecting a life with 2 children, a house, 2 cars, gadgets, and profligate energy use. This expectation is over. We have a large population of competitors now, especially in the BRIC nations, who will do that work for a more reasonable wage rate.

This transformation has significant horrors to some. The liberal US elite will look for the wealthy to share more of their spoils. The global elite will be a bit more disconnected, as replacing labor in one nation for another, isn't anathema.

No doubt management could have been better...but, in the end, the middle class in the US (and soon in Europe) can not expect the spoils of capitalism they've come to expect.

The investor community will not support a model where unskilled and semiskilled workers in the US get $40/hour in wages (or more, with benefits), in order to produce a crappy automobile. No longer will the investor community support financial institutions which don't manage credit risk better.

The root of this current crisis was the insufficient attention financial institutions put on managing risk in the CDO market. Just because a bank's letterhead was on a contract, it didn't make it safe. A few trillion got pushed around because of greed and purposeful negligence. And now, the investors must panic, flee, and regroup.

Can this panic in the financial markets be curbed by Keynesian doctrine? Who knows. Throwing good money at bad ventures isn't a recipe for success.

Perhaps there simply has to be a resetting of expectations. Perhaps the proverbial american dream is really over. Why should an american citizen expect better spoils from global capitalism than their counterpart in china or india? Perhaps they simply deserve their lot.

[Kaleberg]

Too Much Fed: I believe it is the lower and middle class that needs recapitalized NOT the banks. Wouldn't paying back more of the debt "recapitalize" the banks and help the credit system?

---

This suggests an alternate approach, a mortgage interest tax credit. It's sort of like the earned income credit, except the money is earmarked for the banks and investors. Basically, if you pay $12,000 a year in interest, you get your deduction, plus some credit based on your income. I'd guess something in the $1,200 to $6,000 range. This might make the difference in letting people stay in their homes which lowers other governmental costs. The government is already on the hook for hundreds of billions payable to the banks, so this not only bails out the banks, but their victims as well. Sure, a lot of people bought more home than they could afford, and I suppose you could argue that this would hurt the rental market, but it has other advantages.