Crash Landings: Paul Krugman's Depression Economics
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.