A decade ago, Paul Krugman wrote a little book warning us that economists’ triumphalism was misplaced -- that advances in economic knowledge and economic policy had not, after all, banished the prospect of big depressions from the global economy. “The Return of Depression Economics” sank with barely a ripple. After all, the East Asian financial crisis of 1997-98 -- although sharp -- was short and quickly cured once the International Monetary Fund realized that the crisis was not the fault of governments and once Senate Republicans allowed the U.S. Treasury to intervene in world markets. Japan’s economic problems during its lost-growth decade of the 1990s were, economists asserted, peculiar to itself. And the collapse of the dot-com bubble in 2000-01 brought on not a depression but merely an output decline so mild as to barely warrant the name “recession.”
Now Krugman is back, armed with a Nobel Prize for economics and a crisis that is orders of magnitude worse than the East Asian one. And he is back with more than a second edition in “The Return of Depression Economics and the Crisis of 2008.” He returns with a stronger argument, as the current financial crisis serves as a third example, alongside Japan’s lost-growth decade and the East Asian crisis, of “depression economics.”
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 -- for it is only by knowing depression economics well that we can figure out which of the standard remedies is likely to be effective in any particular case, and how strong a dose will be needed.
If liquidity is king
What is “depression economics”? Cast yourself back 500 years ago to the docks where Antonio, the merchant of Venice, is loading the goods for a venture onto one of his ships: the spices of the Indies, the silks of Cathay and the intoxicants of Araby. But in order to carry out his venture, he needs investors: Shylock, say. Suppose that the morning comes to set sail and Shylock balks -- says that he needs his money now to pay for the wedding of his daughter or that the venture is too risky and he wants to keep his wealth close at hand.
Suppose also that Shylock’s change of mind is a general change of mind -- that no replacement financier can be found. What happens? With a sigh, Antonio unloads his ship and carries his spices, silks and intoxicants off to the local market, sells them and then returns his money to Shylock. No big problem.
Now flash-forward to today. The capital stock of our economy no longer consists of valued consumption goods -- spices, silks, intoxicants -- for which there is a ready consumer market. The capital stock of our economy instead 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 rather than in the five to 10 years it will take enterprises to pay dividends) or safety (the world is risky enough, thank you, and they don’t care about the upside as long as they are protected on the downside)?
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.
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 what he terms the “obvious solution”: financial sector rescues, 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 launder the money: to itself assume partial or complete ownership of risky banks and portfolios, and finance its purchases by issuing its own safe debt backed by its full faith and credit.
Others have done it
As Krugman writes, we know how to do this: Sweden did it in the early 1990s, investing as much in its banks in proportion to its economy as $500 billion would be for the U.S. today. Japan did it in 1998, investing the equivalent of $2 trillion when scaled to the U.S. today. And as a next step, Krugman recommends a “good old Keynesian fiscal stimulus”: When the private market will not provide enough demand to keep America near full employment, the government should think of something that needs to be done and hire people to do it until the economy is back near full employment.
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 when there isn’t a crisis so that it doesn’t take excessive risks” -- that is to say, if things turn out badly, the entire financial sector won’t freeze up.
The dot-com crash did not threaten to produce a depression because the venture capitalists did not claim to be providing liquidity and safety. The East Asian crisis of the late 1990s did cause a small depression because East Asia’s banks had borrowed in dollars and lent in baht when the regulators were not watching. 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.
We won’t make this mistake again.
At least not for a generation.