In Paul Krugman's illuminating work, The Return of Depression Economics and the Crisis of 2008, the financial crisis that continues to play out is explained in surprisingly easy to understand language. He offers readers a history of past financial crises to setup his view of the causes, effects, and possible solutions to our current economic woes. While the title may seem ominous, Krugman maintains a positive, albeit tenuous outlook for the future.
The chief goals of this updated edition, as highlighted in the book's introduction, are to answer three important questions:
- How could this catastrophe have happened?
- How can the victims recover?
- How can we prevent this from happening again?
In reading through his extensive treatise of past financial crises and their commonalities, he does a terrific job in answering the first question. Additionally, his prescription for preventing future calamities of this sort is sensible and built on sound principles. However, the book lacks details in explaining exactly how victims of this round of financial instability are to recover. Overall, the book offers an important and timely look at the nature of financial crises and is likely a timeless exposition on the subject.
Elements of a Financial Crisis
The first four chapters of the book examine major financial crises in varying detail that include the Panic of 1907, the Great Depression, the savings and loan problems of the 1980s, the Latin American Crisis of the mid 1990s, the Asian Flu of the mid to late 1990s, and Japan's Lost Decade. Within these stories, themes emerge that bear striking resemblances to one another. Virtually all involved an attractive story to bring in new capital to fund rapid economic expansion, loose credit, asset bubbles, a loss of confidence, investor biases, currency complications, and of course, the eventual unraveling of the financial system.
Among these, the most disconcerting is the role that confidence plays in feeding a financial crisis. As Krugman explains, this is a four step, circular process that acts as a feedback loop into a microphone – the sound of feedback grows until it becomes an unbearable screech. The confidence loop is described as follows:
- Begin with confidence
- Feeding the financial markets
- Feeding the real economy
- Then, back again to confidence
Perhaps the most interesting aspect of this phenomenon is the fact that it works in both directions. To fuel economic booms, participants in the economy have a great deal of confidence, so much so that during economic expansion, large bets are placed on the prospects of continued success. However, a financial crisis begins with a seemingly small change that chips away at confidence, eventually turning into a pit of panic.
These facts are explained in detail through the historical accounts given by Krugman. In each case, there was a spark that moved confidence to ever greater heights, only to have it all come crashing down. This process leaves a kind of stain on the minds of investors, policymakers, and everyday people alike. As illustrated with Japan's Lost Decade or the Great Depression, confidence, once lost, can be difficult to regain.
The Power of Speculators
Of course, where these surges and eventual collapses in confidence occur, the power of speculators can be found on full display. As Krugman outlines, speculators often go by the name of 'hedge funds', but these profiteers rarely do much in the way of hedging. Rather, they are fully engaged in turning a profit wherever opportunities exist and at whatever the social costs may be. In the cases of Latin America and Southeast Asia, hedge funds played an important role in the rapid descent of these financial markets and economies.
The basic strategy of hedge funds is to exploit markets by shorting safer assets and then buying long in riskier assets. However, when a market is ripe for a financial crisis, these speculators will engineer trades that will shake the stability of a country's financial markets with currency being a prime target. In each of the cases outlined by Krugman, hedge fund managers leveraged positions up to 100 to 1 in an effort to devalue a target nation's currency. Indeed, they created windfall profits for themselves in virtually every instance.
Unfortunately for those living in targeted countries, speculators' profits meant an enormous amount of economic pain. As a singular example, Argentina's currency lost 70% of its value due, in part, to the role of hedge funds. This devaluation caused a great deal of pain and hardship for Argentinians, but social costs are irrelevant to profiteers.
This brings into focus the question of regulation. If hedge funds offer no social value (or in this case, create social harm), how can they be allowed to operate so freely? The answer to this question is hedge funds are largely unregulated and take great care to stay away from the watchful eyes of regulators. With free reign to operate as they please, these speculators can wreak havoc around the world without fear of any serious repercussions.
As disheartening as this may be, hedge funds are not alone in taking advantage of regulatory blindness. Krugman skillfully parallels the so-called shadow banking system with the operations of hedge funds. In both cases, profits were the motivation, leverage was used at mind boggling levels, each engaged in some form of risk arbitrage, and in the end, both created widespread financial destruction. The only difference between them is hedge funds profited from the downward spiral while once venerable companies like Lehman Brothers collapsed.
This is where Krugman does a superlative job in writing. It would require many volumes of text to fully explain the shadow banking system and the complex schemes and instruments used, but Krugman gives the right level of detail so readers can understand how the world was blindsided by a banking system that few knew existed. At one point, he estimated that the traditional banking system had $6 trillion in assets while the shadow banking system accounted for another $4 trillion. It is almost unimaginable that a banking system with $4 trillion was completely unregulated.
The World, Blindsided
High finance is littered with very intelligent people, but left unchecked, a financial train wreck is the inevitable outcome. Just as hedge funds had laid waste to Southeast Asia and Latin America in the latter half of the 1990s, so too did the shadow banking system – only this time, it was not confined to a region, but became a global calamity that few saw coming.
Drawing on the themes of financial crises past, this current wave of panic bore a striking resemblance to all its predecessors. Profit was available, leverage multiplied profits, a bubble popped, confidence was shaken, and finally, disaster. The only difference was that this crisis had its roots in the United States, a previously unthinkable possibility.
As the largest economy in the world, many believed that the problems of subprime mortgages could be contained. In fact, Treasury Secretary Paulson issued just such a statement in September of 2007. As it turns out, his assessment of the size and scope of the problem was terribly off the mark.
Once the subprime crisis was in full swing, a crisis of confidence developed. The shadow banking system – largely dependent on borrowings between banks – began to show signs of great duress. With rapidly falling confidence in financial institutions, companies attempted to deleverage quickly, selling off assets and abandoning loans to other institutions. This compounded the problem, following the same cycle of confidence degradation that all financial crises share. The net result was the deepest recession in a generation.
The Return of Depression Economics
It is at this point that Krugman offers some advice on what must be done to move out of recession or at minimum, avert a depression. His recommendation for the immediate future is to get credit flowing again and to prop up spending by any means necessary. In addition, he believes that depression economics must be used and that policy should focus on demand side macroeconomics. Outside of the immediate needs, Krugman proposes global, coordinated financial reforms for any financial institution or market that meets a very plain definition: anything that needs to be rescued in a financial crisis must be regulated.
What were the answers to Krugman's three important questions? The catastrophe was hatched in a $4 trillion unregulated market and eventually collapsed under a downward spiral of confidence. This crisis had victims in all corners of the globe, but there is no clear path towards recovery. The flow of credit and fiscal stimulus are good starting points, but much more will be needed. Finally, to prevent another crisis of this magnitude, regulation will play an important role, but it would be foolish to believe that this will be the last.
Left with Wanting
The Return of Depression Economics and the Crisis of 2008 is a fantastic work that can be easily comprehended by anyone with a basic understanding of economics. However, the book leaves the reader wanting a more detailed proposal for what must be done to repair the damage created by this crisis. With respect to Krugman's call for a return to depression economics, greater elaboration on what this would look like is needed. In the end, this is a book that richly rewards the reader, but could have been improved with an extra chapter to expand on some of the potential solutions – solutions that likely have not been seen in many, many years.
Our Rating: 4 Stars - A superb big picture guide to the crisis