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