Depression Economics

The Return of Depression Economics and the Ciris of 2008
Paul Krugman

The Great Depression of the 1930s – a gratuitous, unnecessary tragedy

Could be a garden-varity recession if only Herbert Hoover hadn’t treid to balance the budget in the face of an economic slump; if only the FED hadn’t defendd the gold standarf at the expense of the domestic economy; if only officials had rushed cash to threatened banks

Are we going to make the same mistakes? Can we avoid another depression and stop the business cycle?

1990s – Asian economic slump (struck out of a clear blue sky – a troubling omen

In the modern world, deposit insurance and the readiness of the FED to rush cash to threatened institutions are supposed to prevent such scenes.

The collapse of socialism, the rise of Asia’s capitalist economies

Contrary to what most people expected, the “transition economies” of Eastern Europe did not quickly become a major force in the world market, or a favoured destination for foreign investment. A few countries – Poland, Estonia, the Czech Republic- are starting to look like success stories. Other governments that had relied on its largesse were now on their own (Cuba, North Korea). Another effect of the collapse of the Soviet Union was the disappearance of the many radical movements. It also destroyed the socialist dream (from each according to his abilities, to each according to his needs)

For the first time since 1917, then, we live in a world in which property rights and free markets are viewed as fundamental principles, not grudging expedients; where the unpleasant aspects of a market system – inequality, unemployment, injustice – are accepted as facts of life. Nobody has a plausible alternative. (?)

The taming of the Business Cycle

The great enemies of capitalist stability have always been war and depression. The Great Depression came close to destroying both capitalism and democracy, and led more or less directly to war. It was followed, however, by a generation of sustained economic growth in the industrial world, during which recessions were short and mild, recoveries strong and sustained.


Lack of “effective demand”, too little spending on real goods

Bad things can happen to good economies.

A recession is normally a matter of the public as a whole trying to accumulate cash and can normally be cured simply by issuing more coupons. The Great Depression was brought on by a collapse of effective demand and that the FED should have fought the slump with large injections of money.

If the central bank is overoptimistic about how many jobs can be created, if it puts too much money into circulation, the result is inflation. And once that inflation has become deeply embedded in the public’s expectations, it can be wrung out of the system only through a period of high unemployment. Add in some external shock that suddenly increases prices – such as a doubling of the price of oil – and you have a recipe for nasty, if not Depression-sized, economic slumps.

Technology as Savior

The romance of capitalism – Henry Ford

Spread of prosperity

The fruits of Globalisation

The “Third World” – allying themselves neither with the West nor with the Soviet Union

Low tariff barriers, improved telecommunications, the advent of cheap air transport – reduced the disadvantages of producing in developing countries

Capitalism – good? Skeptics and Critics



The tequila crisis caused one of the worst recessions to hit an individual country since the 1930s. (could devalue, raise interest rates).

In the late 1970s the Mexican economy entered a feverish boom, fed by oil discoveries, high oil process and large loans from foreign banks.

Brady’s Plan


US would not approve any funding for Mexican rescue. It turned out that the U.S. Treasury can, as its own discretion, make use of the Exchange Stabilization Fund, a pot of money set aside for emergency intervention in foreign exchange markets.


 By 1989 the nation was suffering from the true hyperinflation, with prices rising at an annual rate of 3000%
Arentina lower-profile rescue came via the World Bank, which put up $12 billion to support the nation’s bank.

The tequila crisis was caused by Mexican policy errors – notably, allowing the currency to become overvalue, expanding credit instead of tightening it when speculation against the peso began, and botching the devaluation itself in a way that unnerved investors.


The world’s second-largest economy is still blessed with well-educated and willing workers, a modern capital stock, and impressive technological know-how. It has a stable government, which has no difficulty collecting taxes. Unlike Latin America, or for that matter smaller Asian economies, it is a creditor nation, not depending on the goodwill of foreign investors. Producers sell mainly to the domestic market.

Land, never cheap in crowded Japan, had become incredibly expensive: according to a widely cited factoid, the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.

Japan’s bank lent more, with less regard for quality of the borrower, than anyone else’s. In so doing they helped inflate the bubble economy to grotesque proportions.

A ‘growth recession’ is what happens when an economy grows but this growth isn’t fast enough to keep up with the economy’s expanding capacity, so that more and more machines and workers stand idle.  (‘growth depression’ in Japan)

The 1990s were the winter of Japan’s discontent. Perhaps because of its aging population, perhaps also because of a general nervousness about the future, the Japanese public didn’t appear willing to spend enough to use the economy’s capacity, even at a zero interest rate. -> liquidity trap

During the 1990s the government produced a series of stimulus packages, borrowing money to build roads and bridges whether the country needed them or not. These packages created jobs directly and boosted the economy as a whole every time they were tired.

In late 1998 Japan’s legislature put together a $500 billion bank rescue plan.

Japan’s economy finally began to show some signs of recovery around 2003 à exports of manufactured goods. Japan benefited from Chinese growth too, because many Chinese manufactured goods contain components made in Japan.


All of this was according to the standard script: it was the classic lead-in to a currency crisis, of the kind that economists love to model – and speculators love to provoke. As it became clear that the government did not have the stomach to turn the screws on the domestic economy, it became increasingly likely that eventually the baht would be allowed to fall in value. But since it hadn’t happened yet, there was still time to take advantage of the prospective event. As long as the baht-dollar exchange rate seemed likely to remain stable, the fact that interest rates in Thailand were several points higher than in the United States provided an incentive to borrow in dollars and lend in baht. But once it became a high probability that the baht would soon be devalued, the incentive was to go the other way – to borrow in baht, expecting that the dollar value of these debts would soon be reduced, and acquire dollars, expecting that the baht value of these assets would soon increase. Local businessmen borrowed in baht and paid off their dollar loans; wealthy Thais sold their holdings of government debt and bought U.S. Treasury bills; and last but not least, some large international hedge funds began borrowing baht and converting he proceeds into dollars.

The vicious circle of financial crisis

Financial problems for companies, banks, households -> loss of confidence -> plunging currency, rising interest rates, slumping economy -> financial problems….

Problems not always in close trade partners – Asian countries are often treated as a whole (‘Asian miracle’)

Countries had become more vulnerable partly because they had opened up their financial markets – because they had, in fact, become better free-market economies, not worse. They had also taken advantage of their new popularity with international lenders to run up substantial debts to the outside world. It was that the new debts, unlike the old ones, were in dollars – and that turned out to be the economies’ undoing.

Single currency

There are three things that macroeconomic managers want for their economies. They want discretion in monetary policy so that they can fight recessions and curb inflation. They want stable exchange rates so that businesses are not faced with too much uncertainty. And they want to leave international business free – In particular, to allow people to exchange money however they like – in order to get out of the private sector’s way.

The United States has special features that help it live with a single currency: most notably, workers can and do move rapidly from depressed to booming regions, so that one size of monetary policy more or less does fit all.

IMF: “lender of last resort” for national governments

Jeffrey Sachs believed that Asian countries could and should have behaved like Australia, simply letting their currencies decline until they started to look cheap to investors, and that if they had done so, the great slump would never have happened. Would simply letting the currencies fall have worked better? Sachs argued that by not raising interest rates, governments would have avoided feeling the financial panic; the result would have been modest, tolerable devaluations and a far better economic outcome.

Masters of the Universe

“hedge funds” – investments that are able to take temporary control of assets far in excess of their owners’ wealth

George Soros, a Hungarian refugee turned American entrepreneur, founded his Quantum Fund in 1969. By 1992 he was a billionaire, already famous as the “world’s greater investor”, and already celebrated for the generosity and creativity of his philanthropic activities.

In 1990 Britain had joined the ERM, a system of fixed exchange rates that was intended as a way station en route to a unified European currency.

Greenspan’s Bubbles

Alan Greenspan was the chairman of the Federal Reserve’s Board of Governors

Dot-com bubble

Ponzi scheme

We know why home prices started rising: interest rates were very low in the early years of this decade, which made buying houses attractive. Individual families who saw house prices rising ever higher and decided that they should jump into the market, and not worry about how to make the payments. But it was driven to a greater extent by a change in lending practices. Buyers were given loans requiring little or no down payment, and with monthly bills that were beyond their ability to afford – or at least would be unaffordable one the initial low, teaser interest rate reset. Much though not all of this dubious lending went under the heading of “subprime”.

Why did banks relax their standards?

First, they came to believer in ever-rising home prices.

Second, the lenders didn’t concern themselves with the quality of their land because they didn’t hold on them. Instead, they sold them to investors, who didn’t understand what they were buying.

“Securitization” of home mortgages – assembling large pools of mortgages, then selling investors shares in the payments received from borrowers – isn’t a new practice. Until the great housing bubble, however, securitization was more or less completely limited to ‘prime’ mortgages: loans to borrowers who could make a substantial down payment and had enough income to meet the mortgage payments.

CDO –centralized debt obligation In principle, this was supposed to make the senior shares a very safe investment: even if some mortgages defaulted, how likely was it that enough would default to pose problems for the cash flow to these senior shares…

Cynics said that Greenspan had succeeded only by replacing the stock bubble with a housing bubble.

Banking in the shadows

There is more or less unanimous agreement among economic historians that the banking crisis is what turned a nasty recession into the Great Depression.

The Glass-Steagall Act separated banks into two kinds: commercial banks, which accepted deposits, and investment banks, which didn’t.

The spirit of the times – and the ideology of the G. W. Bush administration – was deeply antiregulation.
The sum of all fears

A bursting real estate bubble comparable to what happened in Japan at the end of the 1980s, a wave of bank runs comparable to those of the early 1930s; a liquidity trap in the US, again reminiscent flows and a wave of currency crises all too reminiscent of what happened to Asia in the late 1990s.

The great US housing boom began to deflate in the fall of 2005. As soon as home prices started falling instead of rising, and houses became hard to sell, default rates began rising.

US government debt is as safe as anything on the planet, not because the US is the most responsible nation on earth but because a world in which the US government collapses would be one in which pretty much everything else collapses too.

The Fed is set up to do two main things: manage interest rates and, when necessary, provide cash to banks. It manages interest rates by buying Treasury bills from banks, thereby increasing their reserves, or selling T-bills to banks, thereby reducing their reserves. It provides cash to specific banks in times of need by lending them money directly.

The fall of Lehman Brothers on Sep 15, 2008

The return of depression economics

While depression itself has not returned, depression economics – the kinds of problems that characterized much of the world economy in the 1930s but have not been seen since – has stages a stunning comeback. The world economy has turned out to be a much more dangerous place than we imagined.

And once the recovery effort is well underway; it will be time to turn to prophylactic measures: reforming the system so that the crisis doesn’t happen again.