Sunday, February 22, 2009

Returning Depression Economics

I was expecting big things from Paul Krugman's extraordinarily well-timed reprint of his 1999 book The Return of Depression Economics.  After all, this guy was a very welcome voice of sanity (both economically and politically) during the Bush years, he writes well and has an ability to distill economic jargon into easy to understand examples, and he just gave a great Nobel Prize lecture.  Positive auguries all.

So why was this book only so-so?  First, to be fair, I am not really his intended audience.  This is a book written for the public at large, for people who may need a footnote clarifying what it means to go short a stock, and not for an economist or anyone working in the financial markets.  It never really rises to indepth analysis, and mostly contents itself with telling the story of various snafus and panics in recent financial history -- he touches briefly (almost incoherently briefly) on the Latin American debt crises of the 80's and their resolution with the Brady bonds, and then goes on to discuss more substantively the collapse of the Japanese bubble in the late 80's, the breaking of the bank of England in 92, the Mexican Tequila crisis of 94, the Asian Flu and Russian Default of 98, and the Argentinian currency board fiasco of 2002. 

Fun stories all, and useful history if you haven't already heard it.  All of these incidents of course bear a striking resemblance to the current dilemma that the US faces.  Every single one is a self-fulfilling debt driven liquidity crisis -- that is, at bottom they are a run on the bank.  Sometimes the problem is on the asset side of the balance sheet (Japan) and sometimes it is on the liability side (Argentina) because the debts are denominated in dollars and the central banks involved can only print pesos, but at bottom they are the same asset liability maturity mismatch as ever.  Krugman outlines the history of each of these in folksy fashion, showing you how they worked, making occasional (though really somewhat less than totally effective) use of an analogy with a baby-sitting cooperative, to illustrate his point, and extracting the general lesson that with international financial markets, as with banks, confidence matters. 

The mystery though doesn't lie in the dynamic of these liquidity events, but in why printing more money doesn't always serve to solve them.  In other words these crises all led, for varying lengths of time, to those economies functioning below full capacity and employment.  The mystery is why problems in the financial markets, which, after all, are just a bunch of numbers representing our relative rank in the pecking order, should lead to perfectly good factories sitting around empty and perfectly good workers going hungry.  And on this mystery Krugman really kinda falls down. 

I don't mean that he doesn't do some useful analysis or make any suggestions.  In fact, just recounting these vignettes of financial history so that you can see that they are all related is worthwhile.  And he also does say useful things about why Thailand, Malaysia, Indonesia, South Korea, Russia, and Brazil were in a no-win situation because a bank run is fundamentally a crisis of confidence, and because the fiscal austerity required to restore confidence is naturally at odds with the expansiveness required to get through a liquidity crisis.  So he does isolate why these countries, at least, weren't able to solve their problem by simply printing more money -- the IMF didn't really let them until it was too late.  To further this conclusion, he puts forward Soros breaking the BOE as arguably quite a positive thing for England -- they were going to devalue eventually anyway, and Soros just made it quick and definitive.

And he also does explain how you could get a run on banks in the US even though the deposits are insured, and the Fed is there as a backstop, which you would think eliminated the possibility of a self-fulfilling crisis of confidence.  The 'shadow banking system' made up of the investment banks, hedge funds, etc ... that has grown up over the past 20 years is (was) now huge, highly leveraged, and every man for himself.  Undeniably though, this is a useful thing to know if you haven't been following the bouncing political ball of the last several years.

But I think his tendency to simply describe these crises lets the more important point slip away unnoticed.  Of course we know what a  pure bank run liquidity crisis looks like.  And of course, we know that they can start over a rumor about a rumor.  But we also know that they rarely do.  And there's really not a single example in those he gives that is a pure liquidity crisis, with no element of solvency crisis.  These things always start because there is a real concern that some over indebted nation or bank is not going to be able to pay, and, frankly, the market is usually right about this.  Perhaps this is not always true, but just as the markets can panic and stampede towards the exits, they often stampede into some promising new area as well, making huge loans on idiotic terms, and setting up the very real insolvency that they only later wake up to.

Take the case of the US currently.  I think at this point, no one is claiming that this is purely a liquidity crisis that will blow over as soon as we get the prozac levels in the financial district water supply back up.  The US as a whole borrowed too much.  And we spent it giving each other back rubs in our McMansions.  Now, I'm sure a good back rub will do wonders for your productivity, but that McMansion is just dead weight.  So whoever loaned you the money to buy it should be worried at this point.  And if the guy that made you this loan has a lot of others like it, he should be worried about paying off his debts.

So the fact that he really just discusses all of these cases as liquidity crises strikes me as fundamentally flawed.  The real thing that catapults you into serious and long-lasting Depression Economics seems to be how the solvency question stands at the point that the liquidity crisis starts.  After all, for all their ferocity, the crises in Asia, Russia, and Argentina were all quite brief.  They all involved a devaluation, followed by one to two years of sharply lower output.  But they all were over after that, and the snap back was pretty spectacular in most cases.  Krugman has a point when he says that there's really no reason for people to stop producing things for any length of time, but in these economies it didn't take long for things to reset to a lower level and start growing again quite rapidly. 

It seems to me that there are two possible (and not mutually exclusive) explanations for this.  First, exports.  If the rest of the world is growing and you have just suffered a huge devaluation, you can at least use your idle productive capacity to sell stuff to the US.  Second, when you devalue your currency, you also get the chance to default on your foreign currency denominated bonds, so you get to restructure your debt.  Chapter 11 is pretty useful for reviving your economy.  For a while of course, no one wants to loan you any more money, but pretty soon they tend to forget all about the nasty default, and you can start borrowing again because after the big bath write-offs, you balance sheet doesn't look so bad.  Or maybe, during the recovery, instead of the government borrowing abroad, companies do it directly.  Either way, devaluation and default in the context of the ability to restructure your balance sheet and start exporting can work out all right.  There is someone to borrow (export oriented companies) someone to lend (dumb bankers back for round two, or the IMF) and someone to demand the shit your make (the guy building his McMansion). 

But what if you can't default?  What if you can't or won't restructure your debt? You just sit there groaning under it, trying to get out of your liquidity crisis by printing money that nobody wants to lend and nobody wants to spend.  I think this is the root of the solvency crisis that Japan experienced in the 90's and the US in the 30's.  It was not just a liquidity crisis that was curable by printing enough money.  Both sides of the credit system were broken in those cases (as they may be in the US now), so no creditor was willing to loan the money and no debtor to take it, because everyone was up to their gills in un-restructured debt. 

The standard response to this impasse is well known and Krugman mentions it, trying as best he can to only slip the name Keynes into the final chapter of the book so that it will not prematurely raise the ideological hackles of the average economical illiterate.  The response is that the government should transfer the bad debts to itself, and then it should print up money and spend it directly, completely disintermediating the banks and private businesses in the normal credit system. 

The Keynesian solution has a lot of merit.  If your economy were closed (that is, if you were neither a net debtor nor a net creditor nation) it seems to me that this solution would be foolproof, so long as you were willing to bring all loans into the government coffers, and so long as you were willing to spend alot.  After all, in a closed system, credits and debts are just a matter of the internal distribution of wealth.  In that case, you could always get the economy moving again just by coming out one morning and saying, "okay, all debt is forgiven".  This would have no net effect.  It would indeed transfer wealth from the spendthrift to the profligate, but aside from this moral objection, I don't see how this collective restructuring wouldn't leave everyone's balance sheet in perfect shape.  And once this great netting out were performed, there would be no reason for one group to force another to liquidate its perfectly good factory unnecessarily, and any new money that the government prints up would be spent rather than simply hoarded by debtors to pay off debt or hoarded by creditors for fear that debtors won't pay them off. 

I don't know that Keynes actually mentioned the banking system as part of this problem, but the more I think about it, the more I see it as a crucial, and as what makes Krugman's book ring hollow to me.  It's not just a matter of expansionary fiscal policy that borrows from taxpayers and spends on bridge to nowhere.  You also have to have some form of debt restructuring that leads to a functional banking system so that the money spent by the state doesn't just go to the very gradual netting out of debts (again, assuming a closed economy).  The new spending doesn't happen in a vacuum, it happens in the context of previously existing balance sheets that set one part of society off against another part. 

So Krugman's book as whole ends up assuming that no matter how indebted we are, we can always print up the money we need to get more indebted, and always convince people to borrow it.  The only way to do this in lieu of a mass forgiveness of debts would be to create inflation, but the Japanese experience has proven that once the system gets stuck in the over-indebted state, it is very difficult to get inflation to take.  As far back as 1933, Irving Fisher realized that the key to stopping this whole debt-deflation mess was raising the price level, and then Keynesian fiscal policy came along as a plausible way to do this, but probably neither of them counted on the levels of debt involved today and on the stubborn resistance people have to letting the government shuffle the deck chairs.  Maybe that level of solidarity, and that ability to simply confiscate the income of the creditors, can only happen in a war?

P.S. The worst part is that being a net debtor nation makes this even worse.  In that case, even after any netting out, you will still owe others money.  You will still be in the hole and having to produce more than you consume for a while in order to pay them off.  This is tough if no one else wants your stuff because you are the one that they usually sell to.  This suggests that we might be lucky to end up like Japan.

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