The Return of Depression Economics and the Crisis of 2008
The Return of Depression Economics and the Crisis of 2008 by Paul Krugman takes an in-depth look at the history of financial crises around the world. He discusses how and why Latin America and Asia went into a recession in the 1990s in the first half of the book. Krugman believes that the economic crash in these foreign countries should have served as a warning to the United States that a recession was coming their way as well. In the second half of the book, Krugman discusses how the United States’ financial system has changed over the years. Some topics that Krugman discussed that I found particularly interesting were the “Keynesian Compact”, the fall of Alan Greenspan, the evolution of the banking system and the shadow banking system, and the housing boom and financial crisis of 2007-2008.
John Maynard Keynes was a British economist whose theories about government economic intervention to save a struggling economy from a recession changed the way that people think about recessions and deficit spending. The "Keynesian compact" term came from what happened in the 1930s, when Keynes was trying to explain to people what causes an economy to fall into a slump. He claimed that the economy isn’t able to pick itself up without a hand from the government. He believed that free markets were not a lost cause, but that they just needed government economic intervention to pull them out of a slump. He claimed that increasing public spending, lowering interest rates, and lowering taxes were all actions that the government could take to get the economy back on its feet again. These actions would encourage the public to spend more money, and the economy would bounce back. After the recovery from the Great Depression, the public believed Keynes that economic intervention from the government could keep the economy stable and keep the unemployment rate down. In the United States, the Federal Reserve has followed the “Keynesian Compact” theory. The Fed is expected to cut interest rates or increase the budget deficit to help the economy if the economy is slowing down and there is a recession on the horizon. However, when Asia and other emerging market economies were about to fall into a recession, the United States encouraged them to do the exact opposite of what the “Keynesian Compact” advised. The U.S. advised that Asia and other countries avoid devaluing their currency, raise their interest rates, cut public spending, and raise taxes. The U.S. advised them to do this out of fear of speculators. A loss of confidence in a country can create an economic crisis, which is known as a "self-fulfilling speculative attack." This happens when a crisis was a result of investors having bad expectations about the country. Investors’ fear of an upcoming crisis in the foreign country is what caused the crisis there. U.S. investors’ fears and loss of confidence in investing in foreign markets was a big contributor to recessions faced by foreign countries.
Alan Greenspan was the chairman of the Federal Reserve from 1987 to 2006. He was known as the greatest central banker in history, until the financial crisis of 2008. Many people blamed Greenspan for the crisis, and he went from one of the most respected people in the public’s eyes to one of the least. When Greenspan was chairman of the Federal Reserve, the U.S. economy was in good shape. However, the increase in the U.S.’ productivity contributed more to the economy’s good health than his monetary policies did. When Greenspan was the chairman, the United States had low unemployment rates and low inflation. These years were the U.S.’ golden days. However, when the stock bubble burst, the U.S. economy fell into a short recession. Even when the recession was officially over, the unemployment rate continued to climb. The recession was declared officially over because industrial production and the GDP were up, but the job market was in poor health. Trying to help the stock market, Greenspan lowered the Federal funds rate all the way down to one percent, which instead helped the housing market and created a housing bubble. Low interest rates allowed buyers to get bigger mortgages, which increased home prices. The housing bubble eventually burst in 2007-2008, and its consequences were disastrous.
In the book, Krugman describes the development of the banking system and the financial crisis’ that United States has faced. The Federal Reserve was created in the early 1900s to handle baking panics. However, bank runs were still possible, and in the 1930s the U.S. went into the Great Depression as a result. In the aftermath of this, it was clear that the system needed to be safer. In 1933, the Glass-Steagall Act was created to help make the banking system safer and to put an end to the fear of bank runs. The Glass-Steagall act separated banks into two different types: commercial banks which accepted deposits and investment banks which didn’t. Commercial banks were not allowed to do anything too risky. As a reward, they got access to credit from the Federal Reserve and their deposits were insured by the Federal Deposit Insurance Corporation (FDIC). Investment banks, however, did not have to comply with strict regulations. In 1999, the Glass-Steagall Act was repealed. Commercial banks started taking more risks, and were no longer safe. This is what brought about the creation of the shadow banking system, which fell after the housing bubble burst. The shadow banking system was comprised of institutions that acted as “non-bank banks”. They do a lot of the same things that banks but do not comply to the Federal Reserve’s regulations. Therefore, they not safe and deposits aren’t insured. Krugman believes that the shadow banking system was one of the reasons for the current financial crisis. He believes that any institution that performs the same functions as a bank does should be regulated just like a bank would.
The United States’ housing boom gradually started slowing down in late 2005, but it took a while for people to notice that the market was not thriving as it once was. Subprime lending was still prevalent because people thought that home prices would continue to rise. People’s hopes for the future were high, so home values continued going up. And as house prices rose, lending to borrowers with little to no credit history was no longer risky for lenders. But when home prices began falling, default rates went up and borrowers that were taking on mortgages that they couldn’t afford in the first place could no longer fully repay their home loans to lenders. Loan rescheduling was also out of the question. Loan servicers were stuck with managing these loans, which they either couldn’t or wouldn’t restructure for borrowers and lenders in crisis. By 2006, homes were incredibly overvalued and lenders and investors of mortgage backed securities accepted the fact that they were going to lose a tremendous amount of money as a result of the housing bubble burst. The housing bubble burst also caused the fall of the shadow banking system, making access to credit scarce.