The Return of Depression Economics – Paul Krugman

January 21, 2024

The Return of Depression Economics and the Crisis of 2008, Paul Krugman, W.W. Norton & Company, pp. 191, ISBN: 978-0-393-07101-6

The Great Depression of 1932, the financial crisis following the joint UK and Israeli invasion of Egypt in 1956, the International Dept crisis that came at the heels of two energy crises of the ‘70s, the East Asian Crisis of 1997 that coincided with the Russian economic crisis following the dissolution of the Soviet Union, the seemingly perpetual financial instability in Latin America and lastly, the Great Financial Crisis – these are but a few major financial events that shook the world in the 20th century and at the beginning of the 21st. In an update that brings the 1999 edition of his book to date with the story of the Great Financial Crisis of 2008, Nobel Prize winning economist, Paul Krugman claims that economists haven’t learned much from any of the previous crises and contends that Robert Lucas’ claim that “the central problem of depression-prevention has been solved” is thoroughly false.  

After the initial ode to capitalism and the “end of history”, market triumphalism is tampered by a sober analysis of the failures of neoliberal economics as evidenced by crises experienced throughout the world. Krugman uses the Tequila Crisis that struck Mexico in the 1980s and 1990s to showcase how a failure to devaluate the currency properly and poorly structured financial instruments, such as the tesobonos, led to an overvalued peso, which in turn led to capital flight. Continual devaluation by the Mexican central government led to need to pay even higher risk premiums to lenders, eventually leading to Mexico paying investors an interest rate of 75%. The disruption in Mexico generated a similar process of speculation which led to Argentina almost going bankrupt, despite its currency board that restricted money supply by pegging the peso to the dollar. As investors lost confidence in the peso, they restricted loans, which led to Argentine banks recalling loans, which in turn affected businesses, and spilled over onto the general population that began withdrawing their deposits, just in case. This credit crunch almost collapsed the economy.

Latin American crises were caused by deregulation in the financial sector, imposed by the dominant ideologies of the time and implemented by Chicago, MIT and Harvard trained economists then staffing ministries. Deregulation often allowed for financial speculation, a process by which capital is diverted to financial instruments outside of the real economy, like infrastructure investments or factories. In Japan, this led to a situation where workers and machines stayed idle as economy was expanding, leading to a “growth recession,” creating a bubble that eventually burst and led to the Lost Decade. From 1990s to early 2000s, the Japanese economy grew at around 1% on average, well below other industrialized nations. As capital was not receiving high returns in industrialized nations, it fled to “emerging markets,” only to create a speculative bubble there, however, with a much more significant impact.  

Krugman evaluates these crises and the response to them by the IMF and the US Treasury by way of the Keynesian compact, which goes directly against the measures that were implemented. The dominant mode of thinking in the ‘90s and 2000s was that when faced with a slump, recession or a depression, market confidence needs to be restored and money expenditure cut down by implementing different austerity measures (raise taxes and interest rates, cut social spending), which together only exacerbated slumps.  

In bringing his argument to bear on the 2008 Great Financial Crisis, Krugman analyzes the rise of shadow banking and various financial instruments that came after the repeal of the 1999 Glass-Steagall Act, which separated commercial and investment banking and provided for rules governing investment behaviors, notably barring members banks of the Federal Reserve from investing in non-investment grade securities. Following the same pattern of anti-regulatory behavior and financial liberalization of yore, the 2008 crisis began with housing bubbles and Dot-com bubble of early 2000s. Once that bubble burst, Greenspan’s lowering of interest rates stimulated reckless behavior in capital markets, with mortgages being given to financially unsound borrowers, whose debt was then securitized and sold away to other banks, who eventually found themselves with trillions of dollars in risky loans and eventually collapsed. Once the banks started collapsing, mistrust in the system led to investor panic and defaults, leading to unemployment, homelessness and many other social ills.  

Ultimately, Krugman states that economists have learned all the wrong lessons from previous crises. Instead of changing their ideas of how to manage them, they have continued introducing more of the same. Supply-side thinking which leads to policies restricting money supply have made crises worse and led to the return of “depression economics” where “insufficient private spending fails to make use of the available productive capacity.” For Krugman, the solutions are obvious. More capital needs to be put into financial institutions and people’s pockets by way of increased public spending, recapitalization and direct lending to non-financial institution by the Federal Reserve, despite the opposition. Moreover, if there are certain financial systems and structures that can cause these crises to occur, it should naturally follow that they ought to be regulated, and the government is best suited to do the regulating.  

Krugman’s book is written with a general reader in mind. He gives an overview of the crises and proposes general solutions, without going into specifics, which minimizes the impact of his arguments.

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