2008 Versus 1998
Brad DeLong asks a very good question: why did I see the 1998 crisis, which by some measures ended fairly quickly, as an omen of much worse to come; and why was 2008 so much harder to deal with?
My first answer is that the 1998 crisis was not, in fact, resolved all that easily. Bear in mind that there were really two crises: the high-speed capital-flight crises of Southeast Asia and the prolonged Japanese slump. The capital-flight crisis did subside quickly -- although even there it left permanent damage (Indonesia, with a bigger population than all the other crisis countries combined, has never recovered to its old growth track.) But Japan's woes went on and on. And Japan was the clearest omen for the United States.
My second answer is that there was something mysterious about the recovery in 1998. Brad lists various good things that Rubin and friends did. But the scariest moment came when the failure of LTCM froze the credit markets -- and the truth was that while Rubin and Greenspan unfroze them, that was something of a miracle: they didn't DO anything, they just acted highly confident, and for some reason that worked. There's a line in Depression Economics where I describe them as being like a general who rides in front of his routed army, waves his sword around, and somehow rallies the troops. And economic policy should not be based on the assumption that leaders can always work miracles when needed.
Even where policy played a more comprehensible role, it did so in ways that might not be repeatable. When Rubin rounded up the banks to help Korea, that worked only because Korea's financial markets weren't really that open (yet): if you could plug the flight of capital via banks refusing to roll over their loans, you could get most of it. What would happen if a country was suffering capital flight that you couldn't control through that kind of informal control? Btw, Malaysia, which like Korea managed to recover quite quickly, did so through explicit capital controls, which were deeply opposed by Washington.
But my main answer to Brad's question is that the events of 1997-1998 were, for me, a wake-up call. Before then I'd taken it for granted that central banks could always pump up demand, but Japan showed that the liquidity trap was a very real danger in a world in which inflation rates were fairly low, limiting the ability of central banks to achieve strongly negative real rates. I'd also assumed that bank runs were a thing of the past, but the Asian and LTCM crises showed that events functionally equivalent to bank runs could happen even if depository institutions - the denizens of big marble buildings with "FDIC insured" signs in their windows -- were protected.
So I didn't take much comfort in the fact that a makeshift, cobbled-together set of measures managed to contain the crisis; it seemed all too obvious that the next crisis could be too big for improvisation to handle.
A historical parallel: the Panic of 1907 was contained through the heroic efforts of J.P. Morgan -- but people at the time didn't take that as an indication that things were fine. Instead, they realized that you couldn't always count on having a JP Morgan around when you needed one, so they created the Federal Reserve system. We should have reacted the same way in 1998, but we didn't, and now we see the results.
I find this report (actually a set of thematic charts) by Richard Koo to be very useful and idea provoking in comparing Japan's "balance-sheet recession" with the developing situation now.
http://www.csis.org/media/csis/events/081029_japan_koo.pdf
very well worth glancing at.
December 16, 2008 10:03 AM | Reply | Permalink
"they just acted highly confident, and for some reason that worked." -P Krugman
That's one of the mysteries. Sometimes a refusal to see just how bad it is ameliorates things enormously. The market is a human artifact and responds to sentiment. Why else would we look at the VIX and other sentiment indicators?
December 16, 2008 10:06 AM | Reply | Permalink
This financial tsunami was caused by an incestuous relationship between the Legislative and Exective branches of Government and Corporate America, and if the story isn't told of actions taken or not taken, with names named, it will just happen again.
December 16, 2008 10:27 AM | Reply | Permalink
Couldn't agree more. The NYT "The Reckoning" series has been pretty good at illumunating the history of this sordid affair.
http://topics.nytimes.com/top/news/business/series/the_reckoning/index.html
And as far as naming names, just list everyone in a position of power over the past decade or two, and you're off to a pretty good start.
December 16, 2008 11:11 AM | Reply | Permalink
Dorn,
I read the NYT report, it was a good start.
Everytime I see Dodd or Schumer on TV I throw a shoe at them.
A Rogues Gallery of politicians should be created
containing all those who either aided and abetted, or just stood by quietly as the sharks were allowed to operate willy nilly.
December 16, 2008 4:12 PM | Reply | Permalink
Mr Krugman, thank you for your outspokenness and candor.
I have a question regarding the viability, and reliability of our stock markets and how much they may have been a cause and effect in the current economic crisis.
I know I am not alone in calling the markets legalized (and subsidized) gambling. Where there is gambling there are inflated house odds and an abundance of cheating, wherever and whenever possible.
The Madoff Ponzi scheme is extremely troubling. Today, a stock manipulation attempt by the chief executive of National Lampoon, came to light. These revelations, which happen almost daily, seem to be the norm more than the exception.
I recognize the importance of the markets to our economy but fear they can also be an instrument of our downfall.
December 16, 2008 10:39 AM | Reply | Permalink
And economic policy should not be based on the assumption that leaders can always work miracles when needed.
Quite so. Yet, as economics is undoubtedly a largely psychological science, I wonder if there shouldn't be more research into effects like this. After all, if e.g. a charismatic Fed chief is on balance better for the economy, we ought to be able to (1) analyze that effect numerically, and (2) include it in a set of official economist recommendations to the appointing president.
You could likewise make the argument: "But whether or not we get health care reform should not depend on having a charismatic, motivational advocate in the White House." Maybe it shouldn't, but in the real world these effects should be studied and exploited.
December 16, 2008 10:47 AM | Reply | Permalink
Oh for the love of...
This is why economists are rarely right, always contentious, and generally seen as clueless. Economics is actually the examination of how humans react to money. It's not a science, it's sociology. One cannot write equations complex enough to mirror or predict human behavior. In fact a good or bad economy is almost wholly a function of expectations.
Belief in a leader to bring about positive outcomes is literally all that's needed to have a good economy. Most people understand that, at least subliminally. It's the largest reason Obama won the election. It was also the magic of Ronald Reagan and Bill Clinton. They made the country feel good about itself and the country responded in kind.
I believe Mr. Krugman has said elsewhere that we are suffering a negative mindset in the banking system, that inhibits lending. If so, then it seems logical a positive mindset would alleviate the problem.
Rather than being non-plussed that attitudes have consequences, find something positive to say about our circumstances and/or our prospects. For instance, we are wringing out excesses in the financial sector which will bring future stability. It may sound like an invitation to cheerleading, but so what? Is it preferable to reading a litany of all that's wrong day after day? Instinctively you know that will demoralize the very people who need encouragement. I don't really think you want to do that.
December 16, 2008 11:10 AM | Reply | Permalink
Nothing to see here. Be postive. Move along.
December 16, 2008 11:23 AM | Reply | Permalink
Let me take shooter242's insight a bit further.
FDR and his Brain Trust's programs -- and especially, FDR's anti-business rhetoric ("They are unanimous in their hate for me, and I welcome their hatred") -- destroyed business confidence and prolonged the Great Depression.
What responsible businessman is going to invest when the White House is occupied by an economically irresponsible fool* who treats you as an enemy?
* According to Frances Perkins, Keynes, after meeting with the President (May 28, 1934), told her that he had "supposed the President more literate, economically speaking."
December 16, 2008 12:16 PM | Reply | Permalink
Japan showed that the liquidity trap was a very real danger in a world in which inflation rates were fairly low, limiting the ability of central banks to achieve strongly negative real rates.
Another dumb question: Why not strongly negative nominal rates? If the goal is strongly negative real rates, what's the difference what the inflation is?
December 16, 2008 1:18 PM | Reply | Permalink
Strongly negative nominal rates should cause a run on deposit-taking institutions. If keeping your money in the bank costs 3% a year, your mattress looks like quite a nice alternative. Or you could buy a nice, fancy safe to keep your cash, and still come out ahead.
In an idealized cashless society, where all money is digital and must be kept in some form of financial institution, then I suppose negative nominal rates might be possible. At least imagining such a world might make a decent premise for a novel.
And I'd never say negative nominal rates are utterly impossible: 3 month T-bills traded briefly at a tiny negative yield last week. But that's anomalous, and only is remotely rational in a world where return of capital is far more highly valued than return on capital.
December 16, 2008 3:23 PM | Reply | Permalink
This makes sense. But then, the mattress must be the rational alternative when real-but-not-nominal rates are strongly negative too, no?
But that doesn't create a run because... people are still seeing balances going "up?"
Man, it just gets weirder and weirder.
December 17, 2008 9:43 AM | Reply | Permalink
. . . they realized that you couldn't always count on having a JP Morgan around when you needed one, so they created the Federal Reserve system. Paul Krugman
So, Perfess'r -- and on the understanding that Walter Bagehot and J.P. Morgan weren't available --
On December 11, 1930 -- the day the Bank of United States (New York persuasion) failed -- who'd you rather have in charge? A latter day if less imposing JPM or the Federal Reserve Bank (New York persuasion)?
December 16, 2008 1:46 PM | Reply | Permalink
The Panic of 1907 was contained through the heroic efforts of J.P. Morgan -- but people at the time didn't take that as an indication that things were fine. Instead, they realized that you couldn't always count on having a JP Morgan around when you needed one, so they created the Federal Reserve system. We should have reacted the same way in 1998...
That's probably true, but it might be instructive to remember that the Fed didn't prevent the '29 crash, or the depression that followed, and actually made things worse afterwards by raising rates in a futile bid to keep the US on the gold standard as long as possible.
Likewise, it seems probable any post-1998 "cure" would have remained true to the Washington Consensus, as interpreted by the high priests (Rubin, Summers and Greenspan).
New institutions can't prevent disaster if they remain wedded to old orthodoxies, but it takes a whopping big crisis to break the stranglehold of orthodoxy.
December 16, 2008 2:22 PM | Reply | Permalink
In all the talk I have heard and read lately about the need for economic stimulus, I haven't heard much about funding state shortfalls.
Much as I would like to get a couple of thousand dollars in stimulus payments from the government, that doesn't seem like it would help as much as if that same money went to my state government which is supposed to post a 40 billion dollar deficit this year. That means that, in our state at least, education will be making up a large share of the difference. Salaries will be cut and jobs eliminated. Doesn't it make more sense funnel some money down to the state and local employee level to make sure that the already employed stay employed? If they have job security at decent wages, they would be more likely to open their wallets to support our retail/service economy.
Which leads to my second question. I noted a news item yesterday that showed some customer service call centers are returning to the states because a) Americans want to speak to others who share the same language and b) salaries in India have climbed over the past few years.
We were once an industrial powerhouse that exported manufactured goods all over the world. We have seen those jobs depart to lower wage areas of the world. This current economic crisis seems to be hitting them as well, especially China. So, what would be the chances of a resurgence of America's manufacturing base?
December 16, 2008 4:06 PM | Reply | Permalink