Decoding the Krugmanomicon

Paul Krugman's sounding the alarm on the current financial meltdown. He's got Brad DeLong backing him up, among others, saying "If we don't want to wind up in a deep depression or a big inflation, it is time to think what kind of government action we do want to see, and how quickly we can set in in motion." That much I can grasp.

What I don't understand is why this is worse than, say, the LTCM/Asian financial market crisis of the late '90s. One non-bank bank went under. Presumably a couple of other non-bank banks, were they to let the game of Jenga end, might go under. But how many banks are we talking about? And how far will the effects spread beyond finance and housing? Things are bad in the housing sector, but where's the evidence that this is going to have spillover effects into export-manufacturing, domestic manufacturing, services, etc.? People like Krugman and DeLong are much smarter than I am, but they must see evidence that I'm not seeing.

Comments

[Sid]

This is grossly oversimplified, but here goes:

The U.S. economy is more than 66% based on consumption spending. Because real wage growth has stagnated since 2001, Americans have been financing their consumption (and fueling the economy) by borrowing against the rising equity in their house values. U.S. debt-to-GDP ratios show a pretty scary picture. When housing values stagnate for the next decade or so, what will fuel the economy?

Americans have fundamentally been living beyond their means for several years (with the Chinese essentially subsidizing our lifestyle by keeping inflation lower than it should have been). The moment of reckoning is coming up on us.

This doesn't mention the massive overleveraging of assets, exposed liabilities for financial institutions that far exceed their capabilities, the general tightening of credit, etc...

Delong and Krugman both are hoping for a mini-run on the dollar to beef up exports quickly enough, but that won't be enough...

[Stephen]

What I don't understand is why this is worse than, say, the LTCM/Asian financial market crisis of the late '90s.

Why does it need to be? If you were in Asia at that time, it was pretty bad, even if the US wasn't affected by it as much.

I was in Korea then. A majority of young men graduating high school elected to do their mandatory military service immediately instead of putting it off a few years, which meant their families didn't need to support them and they weren't part of the job pool, keeping unemployment down.

The other thing that happened in Korea was that the President at the time called the heads of Hyundai, Samsung, LG and a few other large conglomerates together and told them exactly how they were going to handle themselves: the sacrifices their corporations would make and those that would be made by the top people in each corporation personally. Pres. Kim said to each of them that they were Korean companies and they would do whatever was necessary for the Korean people.

He way overstepped his authority, which is what those CEOs told him. But he pretty much just stared them down, using his personal history (he walked with a limp because of being tortured during his years as a pro-democracy reformer) and public shame to make them do what was right.

Unfortunately, even if we did have a President with a shred of moral authority, American CEOs tend to have no shame. We also don't have a national service program in place that would be able to take a few million young people out of the job market and away from their parents' need to support them.

Oh, and none of the Asian countries in the 90s had been fighting a war that had cost them $3 trillion dollars (and counting) and poisoned the rest of the world against them.

This doesn't have to be the end of America, and while I'm not entirely sure of specifics, I do believe there are things that our government can do to help us all through this. But Bush and the Republicans in Congress don't care enough to help, and the top levels of our economy know that they can make money in any setting, so they aren't going to want to do anything either.

Unfortunately, the question of what the US government will do rests upon the willingness of Nancy Pelosi and Harry Reid to make it happen. I for one can understand Krugman and Delong's pessimism.

[Joe]

"And how far will the effects spread beyond finance and housing?"

But aside from that Mrs. Lincoln, how did you enjoy the play?

As Sid correctly noted, Americans have been using their homes to finance their spending for the past 7 years (including spending on the homes themselves, most damagingly). When that source of financing goes away, spending drops precipitously -- which of course has substantial impact to the non-housing markets.

[BruceMcF]

Stephen has hit the nail on the head. There is no reason to expect this to be worse than the Asian Financial Crisis or the aftermath of the bursting of the Japanese real estate bubble.

In Southeast Asia, most economies were by and large recovered from the Asian Financial Crisis within five to ten years, depending on country, and Japan experienced a decade of stagnant growth interrupted by three recessions in the 1990's, after its Bubble burst.

So, yeah, it may well be no worse than those financial crises. Thing is, most of us weren't living in those countries at those times, and still worse most of us were living in the United States and so were in effect entirely ignorant of what was going on (where hearing an isolated tidbit with no context does not count as "knowing what is going on"), and do not have a gut feeling for what it was like to live through.

[Nicholas Beaudrot]

But people keep saying "worse crisis since the Great Depression". Which, I think, sounds undo alarmism that if we screw this up, we'll end up in Great Depression II, which seems wholly improbably.

It seems more proper to say that we're going to end up in a situation that's somewhat worse than the period from 1975 to 1983, which featured high inflation, stagnant employment, and three periods of economic downturn. Bad, sure. But not bankers jumping out of twentieth-floor windows bad.

[Glenn Fayard]

Now, where exactly did the Krugman-as-Lovecraft-character stuff come from?

[Andrew]

Before I put in my 2c, I'll mention that I'm not an economist by training. Krugman and DeLong are, which may be one reason that they're spooked.

There are four things going on which are coming together:

a) The US has been consuming substantially more than it produces for a long time, borrowing substantial sums from countries like China, Japan, the oil rich nations of the Middle East, and others. See Brad Setser's blog at Nouriel Roubini's site. We depend on these countries to keep providing us financing.

b) At the same time, we've seen a mighty housing bubble which is beginning to unwind. The consumption mentioned in a) is going to have to drop substantially as people get poorer, and as they get cut off from using their homes as ATMs. See, for example, www.CalculatedRisk.com for lots of stuff on this. The drop in consumption will directly lead to economic contraction.

c) If a) and b) alone weren't bad enough, financial deregulation and innovation have resulted in the creation of many investment structures and contracts which have huge nominal values (credit default swaps in total amount to tens of trillions of dollars), and as b) above (the US housing bubble) unwinds, people are beginning to realize that their valuation models for these structures are breaking down. Not only is this causing firms and hedge funds to go bust: there's a pull back in credit activity and trading, which is only increasing the pressure, because no-one knows where the next crisis is going to occur - structured investment vehicles, auction based securities, the monolines?

d) To cap things off, the people in charge are in headless chicken mode. The Fed is improvising, tearing up the rule book, but not looking credible - it was late to admit there was a problem, and appears to have flubbed aspects of the Bear Stearns deal with JP Morgan. The rating agencies have been shown to be hopelessly wrong and compromised. And Bush has only a minimal grasp of any kind of complex issue, forcing him to resort to fatuous statements of optimism and pleas for tax cuts.

Put these things together, and you have a deep and painful trap. The Fed is trying to shovel liquidity into the system to restart activity, but it runs the risk that (a) it won't work, (b) it drives up inflation and (c) it trashes the currency, which in turn pisses of our creditors, who (d) hold our debts in our currency and (e) have been asked to make equity investments in our banks and have been made to look silly by how rapidly these investments have gone south.

So far, the equivalent of the Iraq war's "dirty fucking hippies," as Atrios would say, have been right more often than those in charge. Read Nouriel Roubini (uber-Bear) and Calculated Risk (mild Bear), as well as DeLong and Krugman, to see where we may be headed.