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New crisis, old-time remedy

The Return of Depression Economics and the Crisis of 2008; Paul Krugman; W. W. Norton: 194 pp., $24.95

December 01, 2008|Brad DeLong | Brad DeLong is a professor of economics at UC Berkeley and was a deputy assistant secretary of the Treasury during the Clinton administration.

A decade ago, Paul Krugman wrote a little book warning us that economists' triumphalism was misplaced -- that advances in economic knowledge and economic policy had not, after all, banished the prospect of big depressions from the global economy. "The Return of Depression Economics" sank with barely a ripple. After all, the East Asian financial crisis of 1997-98 -- although sharp -- was short and quickly cured once the International Monetary Fund realized that the crisis was not the fault of governments and once Senate Republicans allowed the U.S. Treasury to intervene in world markets. Japan's economic problems during its lost-growth decade of the 1990s were, economists asserted, peculiar to itself. And the collapse of the dot-com bubble in 2000-01 brought on not a depression but merely an output decline so mild as to barely warrant the name "recession."

Now Krugman is back, armed with a Nobel Prize for economics and a crisis that is orders of magnitude worse than the East Asian one. And he is back with more than a second edition in "The Return of Depression Economics and the Crisis of 2008." He returns with a stronger argument, as the current financial crisis serves as a third example, alongside Japan's lost-growth decade and the East Asian crisis, of "depression economics."

His thesis makes me want to say "no" and "yes." No, Krugman is wrong when he worries that the disease of the business cycle "long . . . considered conquered . . . had reemerged in a form resistant to all the standard" remedies. The standard remedies still do work. Yes, he is right in his claim that "depression economics" is very relevant to economic discourse and policymaking today -- for it is only by knowing depression economics well that we can figure out which of the standard remedies is likely to be effective in any particular case, and how strong a dose will be needed.


If liquidity is king

What is "depression economics"? Cast yourself back 500 years ago to the docks where Antonio, the merchant of Venice, is loading the goods for a venture onto one of his ships: the spices of the Indies, the silks of Cathay and the intoxicants of Araby. But in order to carry out his venture, he needs investors: Shylock, say. Suppose that the morning comes to set sail and Shylock balks -- says that he needs his money now to pay for the wedding of his daughter or that the venture is too risky and he wants to keep his wealth close at hand.

Suppose also that Shylock's change of mind is a general change of mind -- that no replacement financier can be found. What happens? With a sigh, Antonio unloads his ship and carries his spices, silks and intoxicants off to the local market, sells them and then returns his money to Shylock. No big problem.

Now flash-forward to today. The capital stock of our economy no longer consists of valued consumption goods -- spices, silks, intoxicants -- for which there is a ready consumer market. The capital stock of our economy instead consists of the semiconductor fabrication facilities of Applied Materials, the patents of Merck, the roadbed of CSX -- not at all the kind of things that command money on short notice in the consumer marketplace.

Now what happens when everybody -- or a small but coordinated subset of everybodies -- decides that they want liquidity (their money now rather than in the five to 10 years it will take enterprises to pay dividends) or safety (the world is risky enough, thank you, and they don't care about the upside as long as they are protected on the downside)?

In normal times, when one investor wants more liquidity or safety, another will be willing to take on duration and risk, and they will simply swap portfolios at current market prices. But in abnormal times, they cannot: The semiconductor fabs are long-run, durable, risky assets that cannot practically be liquidated. And so when the everybodies all decide that they want liquidity and safety -- well, the economy cannot magically liquidate the fixed capital stock at a reasonable price. And to liquidate at falling prices creates mass unemployment. This is the key to "depression economics." And this is why the industrial business cycle emerged as a disease of the Industrial Revolution.


'Obvious solution'

Here, Krugman backs off his musings about how this time the disease might be more virulent and antibiotic-resistant, for he proposes none other than the standard remedies. He calls for what he terms the "obvious solution": financial sector rescues, injections of capital into the banking system, Keynesian government spending. He notes that this solution is now underway -- although delayed for a long time, perhaps too long for our good, by the Bush administration's ideological blinkers.

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