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The Return of Depression Economics

By Bob Tattersall

January 16, 2009

Central banks around the world have slashed interest rates close to zero, while their government colleagues have announced huge fiscal stimulus programs, so it is only a matter of time before the global economy regains momentum.

If you believe this, then you might want to invest $28 in Paul Krugman’s updated edition of The Return of Depression Economics and the Crisis of 2008. The original version was published in 1999 and covered the stagnation in Japan and the currency crises in Asia and Latin America. This edition brings us up to October 2008, so it addresses the U.S. technology stock bubble, the housing bubble and the subsequent collapse of the financial sector.

Mr. Krugman may be a Nobel prize-winning economist, but his narrative style makes this an easy review of how these recent bubbles and disasters occurred in spite of the best efforts of bankers, politicians and the International Monetary Fund. Unlike the South Sea Bubble and the Dutch Tulip bulb fiascos, these economic calamities were sufficiently recent that we cannot blame them on ignorance or naïveté. In fact, the recurring theme is that what happened in Thailand, Argentina and Japan in the nineties are not random events inflicted on irresponsible foreigners; they are simply logical economic outcomes. They could just as easily have occurred here.

As a result, the current economic crisis is not “like nothing we have ever seen before” as the hedge fund managers would like us to believe. Actually, it is like everything we have seen before, but all at once: a real estate bubble like Japan, a bank crisis like the 1930s, currency turmoil like the 1990s and potentially, a liquidity trap like Japan.

His review of the Japanese economy in the nineties is perhaps the most interesting because of parallels to our current situation. Early in the decade, interest rates were cut dramatically and the government spending on infrastructure resulted in a budget deficit of 4.3 per cent of gross domestic product. Whether for cultural or demographic reasons, the Japanese consumer simply failed to respond to this stimulus. So, by the end of the decade, the deficit was forecast at 10 per cent of GDP, government debt was close to 100 per cent of GDP and the so-called ”zombie banks” were being bailed out in a $500-billion (U.S.) rescue plan. These ratios are more reminiscent of Latin America, but they still failed to ignite either growth or inflation. It wasn’t until 2003 that Japan reported meaningful economic growth, and that was a result of export demand from the United States rather than domestic policy initiatives.

Fast forward to the present time, and both the U.S. and Britain have central bank interest rates close to zero and the promise of major fiscal stimulus. In spite of this, both economies appear to be dead in the water. According to Mr. Krugman, the answer lies in the “shadow banking sector,” which provided much of the borrowing power behind recent consumer demand. These non-bank banks provided loans to sub-prime homeowners, car buyers, hedge funds, art collectors, etc, etc. These lenders are now out of the picture so it is no surprise that economic activity is subdued.

It also explains why traditional bank lenders can honestly say they are not part of the problem: Their loan portfolios may be up 10 per cent year over year, but total credit outstanding is still down dramatically. The financial levers available to central banks and regulators could not deflate the bubble in shadow banking assets, so their efforts to reflate the economy will likely be equally futile.

Mr. Krugman clearly identifies the problems, but he admits that the solutions are not going to be easy: We need to get credit flowing again by recapitalizing the banks, which probably implies some kind of government control. And we need to prop up spending, with an emphasis on the infrastructure. The good news is that these are not radical solutions, so investors should still recognize the economic landscape when we enter the recovery phase, but this isn’t going to happen tomorrow. More to the point, if you are a bank stock investor, you may not like having the government as your partner setting priorities and profitability targets.