Book Summary: The Return Of Depression Economics 2008 by Paul Krugman.

Book Summary: The Return Of Depression Economics 2008 by Paul Krugman.

Table of Contents

1 "THE CENTRAL PROBLEM HAS BEEN SOLVED"

Krugman tries to make a point that the world believed that depression economics was over but as per him Latin American crisis, Japan's liquidity trap and Asian crisis were warning signals. Thus he says that this subject needs further study and more resources should be invested into it. For Krugman, Depression Economics is still not solved and should be pursued further studied.

2 WARNING IGNORED: LATIN AMERICAS CRISES 30

In my opinion, a better source would be Wikipedia

Tequila Crisis - http://en.wikipedia.org/wiki/1994_economic_crisis_in_Mexico

Economic History of Mexico - http://en.wikipedia.org/wiki/Economic_history_of_Mexico

Latin American Crisis - http://en.wikipedia.org/wiki/Latin_American_debt_crisis

3 JAPAN'S TRAP 56

Japan's liquidity trap is a good lesson. Japan is unlike Argentina and Mexico or other Latin American economies. Japan has a stable government, educated labor force, industrial base, research and development and the financial base that is required to maintain and grow the economy. Thus, Japan's problem warrants a much deeper study, as this could happen to other advanced economies as well.

Krugman attributes the causes of Japan's liquidity trap to a few reasons which are as follows, corruption in the government and banks; an implied assurance that depositors deposits are guaranteed by the government and thus the depositors need not worry, this made banks make bad loans which lead to the asset bubbles in real estate and stock markets; moral hazard as banks were not responsible for the risks and bad loans; and moralistic fatalistic view of the central bank that these are good crashes and asset values are now being correctly valued, which caused depressionary pressure. This fuelled the view among its people that correction was needed and warranted; which lead to a negative cycle of low expectations from people and it became a self-fulfilling prophecies. The Japanese central bank tried to attack this problem by reducing interest rates, but how low could they go? rates had reached zero but still no improvements. In 1995, after almost half a decade the central bank decided to recognize bad debts, this gave some breather to the banks, as they were done with it once and for all... recognized the losses and could move. New lending still failed, the cause speculated by author here is, that this could be because of aging population. Japan had baby boom followed by baby bust this made people save even more and more.

The author's policy recommendations for Japan to get out the typical Keynesian liquidity trap would be to create inflation expectations, not necessary actual inflation. That would reduce savings and increase consumption and investment expenditures.

4 ASIA'S CRASH 77

Baht Crisis, Thailand :- The causes as per Paul Krugman are as follow:- a expansionary monetary and fiscal policy followed by the western countries, which was done to get their economies out of mild recessions, this caused massive flow of money into Asian countries. International banks were generally on the sidelines as most of the money flew in through Wisdom and Luck and similar houses, coupled with this massive flow was fixed or targeted exchange rate that was pursued by the central bank of Thailand. Which lead to excessive monetary and credit expansion in Thailand, imports increased due to surge in spending by affluent customers, salary level increased, exports became uncompetitive leading to huge trade deficits. Instead of having domestic saving feeding loans, it was foreign currency loans that started paying for those deficits. Vola you have a perfect situation where Thailand became dependent on foreign influence. There is important factual point that is brought out here that these deficits were private, this was also the case in Mexican crisis and a lesson learnt here was not to trust private sector decisions. It wasn't the government spending on public projects with foreign money. These deficits made international investors wary. There was moral hazard within Thai finance companies, which investors perceived would be always bailed out by the government.

The warranted devaluation of the currency was to the tune of around 15% but the Baht depreciated over 50% which was mainly due to panic among investors.

The Asian crisis was mainly due to contagion effect. This crisis spread to Indonesia, Malaysia, and Korea, although there was little integration among these economies but just sheer panic caused contagion, as investors in their mind had not differentiated these countries.

5 POLICY PERVERSITY 101

Paul asserts that in the Brazilian 1998 crisis which had followed the Russian crisis, Brazil followed the Washington consensus and increased interest rates, rates were as high as 50% at one point in time; ran balanced budgets; everything extremely opposite to Keynesian compact. Why was such a policy advocated? the answers lies in, that Brazil was asked to do this since it needed to win the confidence of speculators & investors alike.

Brazil tried to maintain its fixed currency rates with dollar and that again was exasperating the problem. A problem compounded by fixed exchange rates. An example that Krugman cites to build his case for floating currency exchange is Australia where in the midst of the Asian crisis the currency depreciated pretty rapidly but also gained pretty quickly as investors and speculators started thinking that it is probably cheap and its a good buy, it went fell to 60 cents a dollar and rose again quickly back to 80 cents a dollar. The Australian central bank did not intervene at all. The problem as per Krugman is, the policy was being implemented to cater to the perceptions of investors and speculators, it became armature psychology class, instead of solving the real economic problems. This reverse Keynesian policy caused recessionary effects in these economies.

6 MASTERS OF THE UNIVERSE 119

This section talks about the stories of the George Soros, principal of Quantum Fund; Malaysian Prime Minister Mahathir, during an attack on its currency; the attack on Hong Kong dollar and how it was saved by limiting short selling and directly buying stocks; the Russian crisis where hedge funds believed that USA would help Russia as nuclear missiles were though as collateral but during the attack the west did not help and hedge funds lost a lot of money; the panic that was created in the markets due to Long Term Capital Management and the subsequent Fed bailout which created another moral hazard, as investors believed that the Fed will always bailout. During LMTC Fed lowered interest rates in two back to back meetings.

7 GREENSPAN'S BUBBLES 139

Krugman talks about the Alan Greenspan and the various moves that he made to handle the deflationary phase by reducing the interest rates. Which some claimed had led to the stock bubble of the 2000 which was replaced by the housing bubble. Greenspan himself said that he was worried about the possibility of 'corrosive deflation' due to which he kept the rates low. This chapter does not have a lot of economic content but just descriptions of events that happened during the 1970's to 2003, or Greenspan's time.

8 BANKING IN THE SHADOWS 153

Krugman brings out a very important point, that this crisis was different because the finance industry had become so different. There were so many financial institutions that were involved in the business of banking (maturity transformation)-borrowing short and lending long- but they were not banks, hence out of regulatory framework. An interesting example that is cited here is the use of the Agency...Securities, ABS,MBS, RMBS etc that allowed investors at investment banks to invest in long assets, the banks tried to provide with some kind of mechanism that involved that investors could sell those securities in secondary markets, one such secondary market was weekly auctions. Lots of the debt was originated in this manner. These institutions were practically out of the normal checks and balances that were put in place after 1930 to ensure investor confidence like capital requirements, FDIC, regulatory framework etc. This sudden panic led to run on this shadow banking.

9 THE SUM OF ALL FEARS 165

Here the Krugman narrates the unfolding of the financial crisis of 2008. He gives credit to Ben Bernanke the Fed chairman, for reducing the Fed funds target rate to historically low levels and also following quantitative easing which allowed the Fed to still lend directly into areas that it seemed fit. Due to the change in the nature of the financial industry itself the Fed followed and unconventional move and expanded the balance sheet by targeting various interest rates in various markets, CP, RMBS, CMBS, ABS, money markets, repo markets, tri-party repo, etc, thus somehow taking over the role of shadow banking.

10 THE RETURN OF DEPRESSION ECONOMICS 181

Krugman says as the world's economists started moving away from demand side economics to supply side, for which Krugman does not hold high regard, I quote "The specific set of foolish ideas that has laid claim to the same "supply side economics" is a crank doctrine that would have had little influence if it did not appeal to the prejudices of editors and wealthy men." As per Krugman, the world was not ready for the depression economics, which is basically reduction in the aggregate demand. The reasons that he cites for this shit to supply side economics was theoretical weakness in demand side economic theory, but demand side economics had practical application had been a success which was proved by actions taken in response to various previous recessions. In the end Krugman gives reasons for pro-regulations and gives few policy recommendation.

***I recommend people to buy Krugman's book to have a more detailed information, and enjoy his elegant style of writing, where he explains the most complex subject in simple lucid language***