[From www.powells.com/review March 3, 2009. HB]



The Return of Depression Economics and the Crisis of 2008
by Paul Krugman

Crash Landings
A Review by Bernard Avishai



"We sometimes, for example, hear it said," writes John Stuart Mill in 
his Principles of Political Economy, "that governments ought to 
confine themselves to affording protection against force and fraud"; 
that people should otherwise be "free agents, able to take care of 
themselves." But why, he asks, considering all the "other evils" of a 
market society, should people not be more widely protected by 
government -- that is, "by their own collective strength"? Much like 
Mill, Paul Krugman likes capitalism's innovations but not its crises 
and thinks that government has a duty to facilitate the former and 
protect us from the latter. He doubts that citizens will get much 
protection from moguls -- or from most economists, for that matter -- 
unless we trouble to grasp how the whole intricate game works, so 
that our legislators will form a consensus about how to regulate it. 
Mill supposed that we needed to see "the Dynamics of political 
economy," not just "the Statics." Krugman knows we need Liquidity 
Traps for Dummies.

So for the past twenty years Krugman has dutifully mapped the 
patterns, worried the numbers and issued his warnings -- as in (now 
we can say it) his seriously underestimated book The Return of 
Depression Economics (1999), a primer on the financial busts of 
Japan, the Asian "tigers" and Latin America, transparently meant to 
caution Americans about their own vulnerabilities. He could not have 
chosen a worse time for prophesy than the end of the millennium. 
Technology markets were booming, Google was just a year old and Enron 
was voted a Fortune "Most Admired Company" (for the fourth 
consecutive year). Meanwhile, a budget surplus was accruing, and the 
Clinton White House, the Federal Reserve and Congress were all in 
agreement that, say, regulating "credit default swaps" would be an 
insult to the professionalism of investment bankers.

What about the problems that had recently hobbled other economies? 
Would not Wall Street rehearse Japan's recession? Then again, most 
thought, what did the Japanese, with their computerless offices and 
hierarchical keiretsu, have to do with entrepreneurial, Lotus 
Notes-enveloped us? Mexico's politically inbred financial 
institutions? What board member of an American insurance company -- 
wired with information, faithful to shareholder value -- would allow 
its executives to underwrite high-risk bets, or indeed any 
transactions, without appropriate reserves? I was, at the time, 
director of intellectual capital at KPMG International, designing a 
worldwide intranet for auditors and consultants; our news filters 
were programmed to cause any story with the word "Greenspan" in it to 
leap onto 100,000 desktops. The digerati, successive presidents of 
the United States -- Andrea Mitchell, too! -- seemed under the spell 
of the old Atlas's shrugs. But young Krugman, I was told (and might 
here and there say), didn't "get it. "

The Return was, as things turned out, the last book Krugman published 
before breaking onto the New York Times op-ed page, from which he has 
persisted in calls for predictability, simplicity and safety for 
salaried citizens who have better things to do than maximize their 
utilities all day long. Krugman championed single-payer healthcare; 
he hammered away at Dick Armey's tax cuts and Karl Rove's winning 
creepiness; after the 2004 elections, he almost single-handedly 
shamed wavering Republican moderates into abandoning their 
president's proposal to let Aunt Sheila risk chunks of her Social 
Security on the stock market. Since 2006 he has become a kind of John 
the Baptist of our Keynesian resurrection, warning as early as a year 
ago that an Argentine-style crisis was looming because global 
investors would eventually learn that Americans, too, were unfit to 
soak up much of their surplus savings, that US financial markets were 
"characterized less by sophistication than by sophistry. "

Now he has reissued The Return, which he has shrewdly subtitled and 
hastily updated -- in part, I suppose, to say, "I told you so" (and 
to make a buck from a different kind of derivative), but mainly to 
reiterate what he has argued all along: that any financial 
institution we dare not let fail we also dare not leave unregulated; 
that a commonwealth must use its powers to spend and invest and 
especially to promote growth when more or less free markets more or 
less inevitably let us down.

For a slender book, The Return is ambitious -- actually, it's three 
polemics in one. The first sketches out the ways financial capital in 
Asia and Latin America flowed, or didn't, to cause sudden recessions, 
or inflationary spirals, or currency devaluations, or all of these at 
once. Various governments, even those trying to play by the rules of 
fiscal conservatives, were confronted with terrible choices: either 
decline to print money, endure recession and let ordinary people 
suffer now; or print money, discourage investment and cause them to 
suffer later. The second polemic draws parallels between what 
happened in these places and what might happen -- actually, what is 
happening -- in America, Europe and more developed parts of the 
world, suggesting what dislocations to expect and remedies to pursue. 
Krugman sighs when thinking about economists -- including, notably, 
his Princeton colleague Ben Bernanke -- who assumed that officials at 
Treasury and the Fed had evolved the means to reduce economic 
imbalances to the point where regulations could be relaxed and the 
term "business cycle" would seem an anachronism.

The third polemic, the thinnest and most implicit of the three, 
consists of arguments scattered throughout the book regarding how 
changes in the "real economy" -- the businesses that actually make, 
transport and design things -- shape financial markets or are shaped 
by them. How, in particular, might revolutionary changes in 
information technology -- producing changes in the structure of 
corporations and their terms of competition -- yield a changing 
financial pattern? Or how might those changes entail a revised 
superintending of the business cycle? Krugman allows, for example, 
that the globalization of industrial markets and their much higher 
rates of productivity -- both the result of a new, pervasive 
information platform -- might have justified Greenspan's 
unwillingness to hike interest rates after the "irrational 
exuberance" of the dot-com bubble, although low rates, both men knew, 
were bound to sustain the value of houses -- in effect, risking an 
even bigger bubble. Krugman writes that it was clear by the 1990s 
"that the information industries would dramatically change the look 
and feel of our economy. "

Still, Krugman doesn't much go into how the new technology worked or 
spread, speeding up big businesses or lowering barriers for small 
ones. What mattered, so he writes, was the sheer visibility of cool 
technology, the "romance" of a new American industry -- the fact that 
high-tech start-ups made entrepreneurship seem admirable "in a way 
that it hadn't for more than a century." The Berlin Wall had been 
torn down, and business magazines "actually became interesting to 
read"; even radical economic theorists were lulled into a "new sense 
of optimism about capitalism," he writes. Krugman's argument here is 
all about perceptions, psychology. What interests him, mainly, are 
the financial traces left by investors acting on assumed changes in 
the commercial environment; and what compels him is how governments 
might respond to any consequent exuberance.

I suppose it is clear by now that the first of The Return 's polemics 
strikes me as the most fully satisfying of the three. And if the 
third were better -- as good as Krugman could have made it -- the 
second would be even more convincing. Make no mistake, the trenchancy 
with which Krugman explains capitalism's dysfunctions -- the fall of 
Thailand's baht, the smooth corruptions of Mexico's PRI -- is reason 
enough to read the book; these sections will embarrass blinkered 
proponents of laissez-faire, IMF austerity and Laffer curves, if the 
headlines have not already. Yet at the risk of rekindling the 
vanities I indulged at KPMG, I am not sure Krugman, or 
macroeconomists more generally, fully appreciate the technology 
revolution that's hit the real economy in recent years -- you know, 
the business innovations whose details that other Times columnist sweats.

A generation ago, as Duke University's Arie Lewin discovered, it took 
about thirteen years for a third of the Fortune 500 to be "selected 
out" -- to fail or be acquired. Before the current crisis, this took 
about four years. Two generations ago, about 60,000 businesses 
started up in the United States every year; before the crisis, that 
number was closer to a million. As Don Tapscott and Anthony Williams 
show in their fascinating series of case studies, Wikinomics, the 
collaborative power of the web is now every start-up's R&D department 
(and every book reviewer's fact-checking department). Even in 1999, 
perhaps 70 percent of the market value of technology businesses was 
booked as "intangible assets" -- reputation, and the capacity to 
innovate -- and more than 50 percent of profit came from offerings 
introduced in the previous year. These changes drove KPMG auditors a 
little crazy; they were not only relevant to the "look and feel" of 
the economy but also to the questions of what generates global 
financial gyrations, how governments might respond effectively and 
what turns a recession into a depression or makes a depression "great. "

Krugman starts by explaining why bad things happen to good people, 
presenting a simplified model of financial crisis, borrowed (he 
acknowledges) from Joan and Richard Sweeney's famous 1977 article in 
the Journal of Money, Credit and Banking -- about, of all things, a 
baby-sitting cooperative in Washington, DC. The co-op was established 
by savvy Capitol Hill professionals, whose decency and respect for 
rules could not be doubted. It issued scrip to govern member 
obligations -- some of which couples got upon joining -- entitling 
bearers to a half-hour of baby-sitting. Members, not surprisingly, 
earned scrip by sitting for a corresponding time. So far, so good. 
But then statics became dynamics. Couples with free evenings might 
try to accumulate scrip "reserves." More heavily programmed couples 
might run low and want to sit for many evenings in a row. Demand was 
greater than supply on weekends. (You get the idea.) And what Krugman 
shows, with geometric logic, is that we get a peculiar monetary 
crisis, a kind of "liquidity trap": "Couples who felt their reserves 
of coupons to be insufficient were anxious to baby-sit and reluctant 
to go out. But one couple's decision to go out was another's 
opportunity to baby-sit; so opportunities to baby-sit became hard to 
find, making couples even more reluctant to use their reserves except 
on special occasions, which made baby-sitting opportunities even 
scarcer." The co-op, in short, went into recession: the fact that 
members were rational -- that is, that they wanted to be prudent -- 
made the system of exchange seize up; as with the current crisis, 
everybody wants to save for the future and wants everybody else to 
"go shopping. "

Krugman shows that the co-op executive was able to allay the problem 
by putting more scrip into circulation (the Sweeneys' article goes on 
to show that this ultimately led to the "scourge of inflation," but 
never mind). The parable's first lesson, or "take-away," is not 
terribly contentious. What such financial perturbations need is a 
kind of gyroscope, government monitors to throw compensatory weight 
around: a central bank to lower or raise interest rates, in effect 
determining the amount of money in circulation, or a ministry of 
finance to, say, peg the currency or allow it to float. What is more 
contentious is Krugman's basic skepticism about the monetary 
conservatism of, say, the IMF in such cases -- a skepticism 
fair-minded readers will come to share. Presumably, if the co-op had 
wanted an IMF loan to buy a laptop, it would have had to promise 
never to increase the amount of scrip coming out of its little print shop.

Much of the rest of The Return is a series of stories about 
government efforts to intervene the way the co-op executive did, 
though the playful tone understandably disappears. Krugman presents 
countries wracked by crises during the 1980s and '90s -- Mexico, 
Argentina, Japan, Thailand and Indonesia. In every case, one finds 
the same disturbing, circular pattern -- financial problems for 
companies, banks and households; leading to a general loss of 
confidence among (usually foreign) investors; leading to a plunging 
currency, rising interest rates and a slumping economy; leading to 
financial problems for companies, banks and so on.

The most fascinating crisis (anyway, the one many of our mutual funds 
lost money on) was Thailand's, from which Krugman means us to draw 
some sobering lessons about Wall Street -- especially about what 
economists call, a little pretentiously, "moral hazard." Thailand, a 
latecomer to the Asian miracle, was changed in the early 1980s from 
an agricultural economy largely by Japanese businesses situating 
factories in the country. So peasants moved to urban jobs, local 
banks and businessmen began to invest in new construction and the 
economy started growing by 8 percent a year. Global capital markets 
responded: after all, communism had been defeated, and interest rates 
were very low in Japan and Europe. By 1997, $256 billion was flowing 
in to emerging markets, especially Southeast Asia.

Just how did money get from Tokyo to Bangkok? This is a central 
element of the plot. A Japanese bank might lend to a Thai "finance 
company" that bundled imported yen, converted it to baht and lent it 
in turn to local real estate developers -- who were, of course, 
paying for materials and wages in baht. This led to a growing demand 
for baht and should have made its value rise -- assuming the currency 
had been allowed to float. But to attract investment to its hitherto 
neglected part of the world, the Thai government had decided to 
maintain a stable rate of exchange between the baht and the dollar. 
So the Bank of Thailand increased the supply of baht and 
simultaneously bought foreign exchange -- increasing its reserves. 
Unavoidably, it also expanded domestic credit, since banks in which 
the converted baht were deposited became eager to lend. All of which 
meant new financing for construction projects, which brought new 
foreign lending and so on.

The inevitable result was a construction bubble. The Bank of Thailand 
tried to dampen things a bit by borrowing back much of the baht that 
wound up in foreign banks. But this stopgap only drove up domestic 
interest rates, making borrowing from abroad even more attractive and 
bringing in more yen. The central bank might simply have let the baht 
rise, as many American economists are insisting the Chinese yuan 
should today. But this would have meant making Thai exports (the 
stuff Japanese companies had come to assemble) more expensive in 
foreign markets -- in effect, killing the goose to slow the 
production of golden eggs.

Then again, too much gold brings tragedy of a different kind. 
Eventually -- Krugman beautifully lays this out -- surging investment 
(such as imported equipment for construction) and consumer spending 
(imported TVs and cars for newly affluent Thais) slowed export growth 
relative to imports. This created a huge balance-of-payments deficit. 
Thais began using foreign currency loans to pay for imported consumer 
goods, while the central bank used its foreign currency reserves to 
defend the baht. In July 1997 the Thai expansion finally reached its 
limit; the economy began imploding. The central bank, its reserves 
depleted, let its currency go: the value of the baht against the 
dollar fell as much as 50 percent over a few months. This proved 
catastrophic, engendering a recession not only in Thailand but in 
Korea and Malaysia as well -- a kind of sympathetic pain, as global 
investors pulled back in panic. The region began to experience what 
countries as different as Argentina and Israel had suffered in the 1980s.

What does Thailand's story have to do with "The Crisis of 2008"? A 
lot. Sure, the profiles of Thailand's and America's economies are 
very different: if we were, much like the Bangkok middle class on its 
binge, spending more than we were earning (and covering the trade 
deficit by increased international borrowing), we hardly imported 
stuff the way the Thais did. Much of our trade with China, for 
example, has been internal to world-spanning American companies, 
which capture the value of designing and marketing a product, and go 
to China only for common components and final assembly. Also, the US 
economy is more resilient than a dozen Thailands: Krugman notes 
particularly the incomparable mobility (he might have added upward 
mobility) of American labor. And the American government has not had 
to defend its currency the way the Thais did. The dollar has been the 
world's reserve currency since World War II; its decline has only 
meant that American extravagance reduced the wealth of the planet's 
middle classes about as pervasively (and, until now, imperceptibly) 
as our SUVs increased its atmospheric carbon. We still count on the 
Chinese middle class investing back in our capital markets a good 
part of the $2 trillion Chinese manufacturers have accumulated 
exporting to us. ("The saving grace of America's situation is that 
our foreign debts are in our own currency," Krugman wrote last year.)

Still, there are important symmetries in the performance of financial 
players. Thailand's crisis was fueled by middlemen who had every 
interest in maintaining the illusion that investments in construction 
and retail could not fail: people who profited from the deal-making 
but not necessarily from the viability of the projects. Go back to 
those Thai "finance companies" that brokered loans for foreign 
investors. The people who ran them were mostly the relatives of 
ministers and other high officials. They were not financial whizzes 
but reasonably supposed that the Thai government would force 
taxpayers to bail out companies whose loans went sour. At the same 
time, their political connections were a balm to investors. On the 
whole, they profited from the upside, making fortunes that encouraged 
them to keep making loans, while feeling insulated from the downside 
-- alas, until the whole artifice collapsed, by which time they were 
rich anyway. Nor did they really face moral hazard; they took other 
people's money and were not at risk if their decisions were reckless or dumb.

The investor complacency engendered by Thai connections may not be 
quite like that engendered by AAA ratings, though ratings often 
masked sweetheart connections between, say, Moody's and its clients. 
But if the profits of the "finance companies" remind you of the 
profiteering of mortgage companies making insufficiently vetted 
housing loans -- or, for that matter, of investment banks selling 
faux-securitized bonds and their derivatives -- well, you may be 
forgiven. Wall Street, as Krugman has recently noted in his column, 
became a scramble for good placement in a Ponzi pyramid: business 
students of mine who'd gone to investment banks and were, after a few 
months, looking for openings in hedge funds did not speak of hazards, 
moral or otherwise.

Which brings us to another predatory financial player -- one that 
will attack Western economies as readily as emerging ones and that 
can make any crisis worse. I am referring, of course, to hedge funds, 
which grew into a dangerously big part of an almost entirely 
unregulated "shadow banking" system: institutions that take your 
money and promise eye-bulging returns but have no regulation. Krugman 
reminds us of the astonishing growth of hedge funds, beginning with 
the legendary assault by George Soros's Quantum Fund on the British 
Exchequer in 1992; that speculation so weakened the pound that John 
Major finally opted out of negotiations to adopt the euro, and his 
government fell. Before the 2008 crisis, ordinary banks managed 
something like $6 trillion; shadow banks (investment banks and hedge 
funds) managed about $4 trillion, $1.8 trillion of which was managed 
by hedge funds.

Hedge funds, it turns out, certainly do face moral hazards; indeed, 
they force hazards on all of us. When they win, "shorting" notionally 
vulnerable currencies and equities, they greatly amplify the flaws in 
any country's monetary policy or corporation's financial strategy. 
But when they lose -- and, Bernard Madoff's scheming aside, Krugman 
thinks their collapse may be the next shoe to drop -- they expose 
wide circles of investors, including pension funds and university 
endowments, to speculative disasters. All fund managers, like CEOs, 
are rewarded for their gaining above-average returns, but how can all 
returns be above average? These are the waters in which hedge funds 
prey. And Krugman is right to insist that real wealth may be 
destroyed by the inevitable collapse of investment pools, not just 
the ethereal wealth of "high net-worth individuals." When times were 
good, the paper losses of funds might recover in weeks. But when 
losses are big enough, and panics wide enough, they engender slumps 
in production, employment -- happiness -- for a whole nation.

What is the way out of crisis? Governments, Krugman shows, are left 
with contradictory choices. As the only driver of demand left 
standing, governments become indispensable investors. And he thinks 
recovery is bound to be prolonged. In his book and his journalism, 
Krugman stresses the importance of very large investments: in 
infrastructure, healthcare, education -- autos, too -- insisting that 
these be big enough to overwhelm depression, systemic and 
psychological; that the worst mistake would be taking a five-foot 
leap over a seven-foot pit "out of fear that acting to save the 
financial system is somehow 'socialist.'" The usual conservative 
pundits will carp about this, warning us about not going too far. But 
who among them seriously disputes Krugman's claims for massive state 
intervention?

Still, we cannot really understand what the state needs to do unless 
we understand how forces outside the financial system drive the real 
economy these days. What investments should government make apart 
from recapitalizing, reregulating and reprivatizing banks? How to 
invest in "infrastructure"? This part of The Return is sketchy and 
leaves one wondering if stories about developing economies help that 
much. Some of the book's asides will seem cavalier even to the people 
featured in those "interesting" business magazines a few years back.

There are two points I wish Krugman had made in the book, things he 
seems to believe based on much of what he has written and said about 
the auto industry in recent months. The first is that emerging 
countries may be like us in the circulation of financial capital but 
are quite unlike us in the circulation of intellectual capital -- the 
more important kind, after all. To recover, those countries focused 
mainly on their financial systems because they were keen to attract 
not just foreign money to their capital markets but the know-how of 
global corporations to their cities. The key was to turn foreign 
investments in plant complexes, or software houses, or management 
teams, into engines of civil society, so that a new class of globally 
competitive entrepreneurs might be born. Intel's impact on Israel's 
Kiryat Gat, like Motorola's on China's Tianjin, is something like 
MIT's on Cambridge. You would not know this from The Return.

But macroeconomics as a profession often seems indifferent to the 
ways production innovations drive economies, at least compared with 
ambient financial conditions. You imagine macroeconomists advising 
farmers to concern themselves mainly with forecasting the weather. 
Krugman writes, for example, that one could not explain the yen's 
wild fluctuations during the past twenty-five years by "measurable 
changes" in Japan's fundamentals. But surely you cannot explain what 
made Japan so filthy rich in the late 1980s, and so susceptible to a 
ridiculously huge real estate boom (and a ridiculously strong yen), 
unless you consider its striking advantages in paternalistic, 
labor-intensive and quality-focused manufacturing in the 1970s and 
early '80s. What Harvard Business Review article in the 1980s did not 
begin with a bow to Japan's "competitiveness"?

Then again, can you explain the yen's fall, or Japan's prolonged 
crisis despite massive infrastructure investments, if you don't see 
that, indeed, new process technologies governed by robotics and 
software advances seriously undercut those older advantages, boosting 
European but especially American entrepreneurship; that the very 
paternalism that made Japan's 1980s factories hum also made employees 
hard to fire and information-driven start-ups rare? What if somebody 
in the co-op had invented a robot to baby-sit? What if members could 
conduct negotiations, or auctions, directly through Facebook? "A 
thing not yet so well understood and recognised," Mill wrote, "is the 
economical value of the general diffusion of intelligence among the people. "

Which brings me to the last point. What has allowed emerging markets 
like Thailand and China to grow incredibly fast, and thus accelerate 
major financial imbalances, is the same information platform that 
will inevitably shape and pace our recovery. Lehman Brothers 
collapsed, and we got into global panic at the speed of light. But 
this was because the same platform that allowed investment banks to 
dice up and bundle mortgage debt in the first place narrowcasted 
specialized reasons for panic to every segmented country and 
industry, pension fund and CFO. What venture capitalist in the world 
was not reading Sequoia Capital's gloomy presentation on retrenchment 
in tech markets the day after it was delivered in Silicon Valley?

But why cannot this same platform, which gives entrepreneurs 
unprecedented powers to inform themselves, speed review of their 
business plans, hire new talent and so forth, be counted on to get us 
out of recession, however deep, at unprecedented speed? Why should 
state buttresses to financial services and investments in the real 
economy not accelerate business formation? Should not Obama's new, 
sturdier regulations, as well as his tax policies, give priority to 
entrepreneurs? Indeed, what venture capitalist will not also know 
within twenty-four hours about Kleiner Perkins's next investment in, 
say, a battery company -- and, within an hour, be telling a friend 
managing the medium-risk portfolio of a sovereign wealth fund in Qatar?

Think again about carmakers. A competitive auto group -- Volkswagen 
Group, for example -- amounts to a global, virtual design center, 
sharing talent and intellectual property across brand units: Audi, 
Skoda, etc. The boss's job is to bring down overhead and transaction 
costs, something like the mogul of an old-time Hollywood studio; the 
goal is to enable multiple experiments, for myriad tastes and 
geographies, so that a brand's niche products can break even when, 
say, only 50,000 vehicles have been sold. More than 60 percent of the 
cost of an automobile is in the "bonnet," the cab and electronics, 
not in the drivetrain; and most drivetrain components are 
increasingly computerized. So Volkswagen Group survives because its 
burgeoning information platform enables its brands to establish 
multiple hubs for sharing intellectual capital -- hubs for deciding 
about aesthetic and performance features, of course (a Skoda Octavia 
is not an Audi TT, though both share the same chassis), but also, 
increasingly, for software refinements invited by suppliers. Usually, 
Audi's designers set performance specifications but get an ever 
expanding roster of suppliers to compete on designing technical 
specifications. BMW, Tapscott and Williams tell us in Wikinomics, 
manages its marketing and supplier relationships and maintains only 
critical in-house engineering expertise. A web of suppliers does the 
rest -- even, in some cases, the final assembly.

The Return gives us little to think about along these lines. So read 
it on the train, and take Wikinomics or William Taylor and Polly 
LaBarre's Mavericks at Work to bed. Then again, when Krugman writes 
in his column about the auto industry, describing a cluster of 
networked suppliers any bailout is really meant to sustain, you get 
the idea Wikinomics and some other new economy books have been on his 
night table, too. He knows, clearly, that whatever the government 
does -- in healthcare and education, too -- it must take into account 
that hundreds of fast, smart companies growing bigger will be the key 
to recovery, not a few established giants getting a makeover.

What made the Great Depression great, after all, was the time it took 
big businesses to be jolted into high activity. But we do not do 
business with gold transfers, patent monopolies and shortwave 
anymore: big does not mean trusted, or controlling, or informed. 
We've heard Santayana's aphorism, and many have been condemned to 
repeat it. But there are things to learn also from the present. And 
we count on nobody more than Paul Krugman to teach us about that.

Bernard Avishai is the author, most recently, of The Hebrew Republic: 
How Secular Democracy and Global Enterprise Will Bring Israel Peace 
at Last (Harcourt).