[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).
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