Paul Krugman: The Return of Depression Economics and the Crisis of 2008

It was actually this book that inspired me to start writing a blog. Well, not so much this book as the fact that I was reading this book. I thought the book would inspire me to thinking and that this blog would encourage me to structure my thoughts and spend a little time thinking about the topic.

So did the book inspire me. Well, somewhat. I found it a little too fluffy. There were lots of unsupported assertions. Assertions about which I believe there remains significant controversy.

Anyway, the core of Krugman's argument appears to be that the "Shadow Financial System" had a fairly classic "run on the bank". That is that financial instruments like auction rate securities behave very much like a bank, i.e., they provide borrowers with secure long-term financing, but provide lenders with liquidity. But they do so while yielding higher returns to the lenders. They achieve this by not being actual banks and not being subject to the regulations that banks face. Many of these regulations are designed to prevent or discourage runs on the bank, and so these non-bank banks face that risk. In the case of auction-rate securities the "run" was brought about when auctions started to fail. Lenders were then stuck with long-term illiquid investments when they thought they had short-term liquid ones. The initial failures lead to a collapse in confidence, now no-one wanted to participate and more and more such auctions failed. This pulled about $400B of liquidity out of the market and lead to the abandonment of auction rate securities as an instrument. Removing not just the liquidity, but also the source of financing. Of course auction rate securities were just one example. But the general principal was: there is a problem --> collapse in confidence --> run on the bank --> problem is greatly magnified.

I guess the other general argument of the book is that demand side economics is important and should have more of a voice. The notion here is that a recession/depression is really a lack of demand. That is, there is unused productive capacity in the economy. But there is no demand for the output of this capacity. One might expect that this would result in a drop in wages, and a drop in prices until goods were sufficiently cheap to stimulate demand. But this doesn't appear to happen.

My favorite page in the book was the last. Krugman says: "Depression economics, however, is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work. The true scarcity in Keynes's world -- and ours -- was therefore not of resources, or even of virtue, but of understanding."

Ah, now I guess it did spur me to at least a little thinking, so maybe it wasn't too bad after all.

9/20/2009: So I actually appreciate this book a little better now. I was listening to NPR about the financial crisis and nobody seemed to quite comprehend the confidence game that is our modern financial system. Someone from the Hoover Institute was even proposing scrapping FDIC insurance. Can you imagine how bad it would have been without the FDIC!! Everyone would have taken their money out. I certainly would have.