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Monday, December 01, 2008

"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.

    Posted by on Monday, December 1, 2008 at 03:51 PM in Economics, Policy | Permalink  TrackBack (0)  Comments (39)


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