Crash Landings: Paul Krugman's Depression Economics
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.