BOOK REVIEW: THE RETURN OF DEPRESSION ECONOMICS BY PAUL KRUGMAN In this book The Return of Depression Economics Nobel

Laureate Paul Krugman shows how sometimes wrong policy measures by the govt. can led to economic crisis that swept across Asia, USA and Latin America in the 1990s and reveals that those crisis were a warning for all of us. Now Depression economics has staged a comeback with the housing bubble of the mid 2000s burst, the western financial system proved as vulnerable as when developing countries were caught up in earlier crisis and a replay of 1930s seemed all too possible. Krugman shows analytically how the above countries were caught up in recessions and laid down the steps to be taken to turn around an economy which is turning into a recession. The book is wake up call to all complacent or economically ignorant policy makers. After controlling and taming the Great Depression of 1930 many economists began to believe that the problem of depression has been solved. Now the govt. through its proper mix of policies can tame the recessions and prevent it from turning into great depression. Capitalism itself is not foolproof with continuous cycles of booms and recessions, it has its pros and cons. On one side Inflation, unemployment and recessions keeps haunting the economy while on the other side Capitalism has bred globalization and has brought development to a large number of developing countries. Many recent developments like Great depression of 2008 have severely challenged the argument that the central problem of economic stability over a long time has been solved. Financial Crisis in Japan, Latin America, and SE Asia signals for adopting a cautious and precautionary approach to maintain stability of the country over a long time. In Mexico the political Spending by ruling parties led the govt. to take large amount of pesos by printing which were converted to dollars, draining the forex reserves. The authority chose to go for devaluation of peso. This however did not attract money into Mexico (due to low rating of Mexico and lack of confidence in the economy of the investors). These further reduced value of peso. Govt. Bonds were not selling and by selling short term bonds at low peso value via dollar, govt. had created a large amount of debt in dollars. So as the peso further devalued, the dollar debt piled up. Short term debts were converted to tesbonos, which were indexed to dollars, as dollar debt mounted the news of tesobonos spread like a panic. Mexican GDP plunged, and govt. did nothing to prevent the economic slump. The foreign investor panicked and their perception that Latin American countries are not different, withdrew their credits in dollars from the banks in Argentina. The deposits of depositors are either insured by the govt. or central Bank floods large amount of money to reserve banks but neither case happened in Argentina. Because the value of deposits depends on the value of the peso against the dollar and central bank was prohibited from printing pesos except in exchange for dollars. In early 1995 both Mexico and Argentina went from Euphoria to terror. This Latin American crisis has learning for other countries and the USA that some wrong economic policies can create major economic disasters. It is the biggest irony that the policy measures taken prior to crisis seemed just but when looked after the crisis busted seemed full of errors. The case with Japan is no different. In the 1990s Japan banking System was backed by the govt., so the conglomerate of Banks called keiretsu believed that their deposits are safe and backed by the govt. The Bank lend heavily at cheap rates to the Businessmen in 1980s, however between 1930 and 1980 the

banking system was highly regulated. But to promote growth, competition, reforms there was deregulation in the economy and the loans were lend at a cheaper rate without checking the quality of creditors. The land prices, stocks prices were sky rocketing. Due to bad loans, and not viable returns from some projects due to low consumption, an economic bubble created that busted to large proportions and Japan tried to reduce it by reducing interest rates. The growth in Japan in 1990s is called the growth Recession because there was a growing economy but the economic growth was not fast to fully utilize economys capacity. So more workers became unemployed and machines stood idle. The bank lowered the interest rate to zero and govt. began spending to create a growth momentum but the growths were short lived. The low interest rate couldnt maintained the economic growth as the population was aged and less willing to spend due to nervousness about the future and were not using the economic capacity. This is a liquidity trap. Beginning 1991 the land prices, stocks prices began to decline steeply. Banks had become weak due to initial lending of bad loans. So country was in a liquidity trap. The govt. needed to support large no. of aged people with pension plans going out of Exchequer. The spending govt. did to bring growth was short lived due to not enough bang for yen. Another victim of the govt.s incorrect policies was the SE Asian Nations Thailand, Malaysia, Indonesia and South Korea which went into financial crisis in the 1997. Prior to the crisis the Thailand economy was growing with stable Baht dollar exchange rate, high interest rates and good businesses flourishing. The high interest rates and good return on projects attracted money from foreign investors especially USA. The Thai exports were competitive and the support provided to Banks by the govt. to help them recover in case of trouble attracted more investments from foreign as well as domestic investors. So there was a growing optimism and in this high confidence state investors begin to invest in the bad projects too and banks started giving bad loans. A highly speculative market and excessive investments in stocks and real estate led to high valuation and pricing of investments. Stocks were trading at very large multiple of P/E and real estate prices were sky rocketing. As there was a large capital inflows in dollar from investors, to adjust for Net balance of payments there was a net negative current account transactions which was a result of high net imports and less valued exports (rise of baht value against dollar). Imports grew mainly on account of large consumption by the people in Thailand on account of rising savings with growth in the economy. But sooner than later the credits turned out to be bad and some projects didnt provide the adequate returns (Many projects which were began to see as viable but they were not as viable in boom time). And with less competitive exports and devalued yen led more predominant Japanese exports. All this caused the investors sentiments to shake and the foreign investors began to withdraw money from the Thailand banks. And bank runs followed. In this way Thailand banks were running out of forex reserves of dollars, so demand for baht decreased and in order to maintain the value of Baht the govt. started selling bonds for baht at high interest rates. IN order to back the investors confidence govt. assured that it has a large reserve of forex which were currency swaps of dollars. The Thai baht went down as much as 50percent. Govt. also couldnt devalued the baht otherwise that would have caused bankruptcy of banks in Thailand. The prices of stocks, real estate and projects went downwards sometimes as high as down by sixty percent. The bubble created by the speculators had busted and many banks went bankrupt. The country went into recession as there were no loan givings by the already troubled banks and higher interest rates ensured that projects are not undertaken and there were not enough opportunities in the business so economy went into a slump and

a recession. The foreign investors saw other SE nations similar to each other and as also they invest in these countries through a Emerging market fund so they were similar in their opinions regarding the economies of these SE Asian nations, Whereby although there was no direct linkages between these countries so that one countrys economy will affect the others economy, but speculators view persisted. So when crisis hit Thailand it went across to Indonesia and Malaysia as well so it was a SE Asian crisis. The Keynesian compact of reducing interest rates, increasing budget deficits to face economic slump was a good measure that govt. can take. However the countries that faced recessions like SE Asian nations did the inversion of Keynesian compact by raising interest rates (to attract investors for investments back), increasing taxes to avoid facing a slump. But the same proved to be a contributor to the recession. The investors felt that once the Thai baht is devalued and thus the economy is coming back to its bad old days and it is not profitable to invest so investors confidence was not restored. The high interest rates and taxes further curbed the spending and further deepened the recession. Instead of winning the investors confidence and try to align with their prejudice, govt. decided to correct its budget deficit first. So the policies as recommended by IMF to follow were anti Keynesian and further worsened the economic slump. However in case of Australia when faced with recession like situation the IMF advocated for free movement of exchange rate and let the Australian dollar to devalue and when the Australian financial assets seemed too undervalued and attractive to investors (confidence in Australian economy) they returned back buying them, so it averted a major recession. But in case of SE Asian nations IMF supported policies of making the govt. to follow anti Keynesian policies which instead of winning back the investors confidence made the Economic situation worst. Hedge funds as the name suggests are financial instruments to go for short and long term positions on currency speculations, stocks, bonds, derivatives. Global speculators begin to emerge with large fund sizes to affect the prices of stocks or currency they are investing in. Similarly some Large Fund Houses went for big positions that could affect the market. IF some Fund house went short on some bonds and if it made huge losses then this caused the Fund house to pay back to the borrower by selling its assets and since these assets size sold is very large this world decrease their value and thus value of other fund houses fall and this resulted in a ripple effect affecting the entire economy. However big fund houses generally play safe by going short on less risky assets and going long on risky and illiquid assets. If at all the Capital inflows are not controlled well then it can affect the entire market of the country in which these hedge funds do their operations. For e.g. LTCM (Long term Capital management) fund in the USA was large fund house managing wealth of billions of dollars. Its sophisticated methods and computations to investment made it a darling of fund houses, so people invested in it without worry. But due to some unforeseen reasons that fund faced trouble and was going bankrupt when FED of USA persuade investors to take a majority ownership of LTCM. By subsequent interest rate reduction by FED brought back the economy on track and saved the fund house. Allan Greenspan is regarded as a messiah who maintains the stabilization of US economy in period 19872006 through ups and downs of wars, recessions, unemployment periods through sound economic policies. He would cut down interest rates in case of recession and raise interest rates during to avoid overheating of economy and inflation. He regarded bubbles produced a result of irrational exuberance of investors. The investors incorrectly invest so much anticipating growth prospects of the asset that

results in irrational valuations of the assets. He reduced the interest rates as soon as the Bubble busted so as to minimally damage the economy and to bring it back on track fast. The stock bubble of the late 1990s was due to overconfidence of the investors in technology stocks and increased optimism for the economy as a whole. Greenspan tamed the recession by decreasing interest rates. Housing bubble was due to increase of investment by people in houses by taking loans from banks backed by mortgage securities. Now mortgages backed securities were rated AAA due to growing housing market and souring prices of the Houses. So Investment in houses was considered a safe and valuable bet. People invested heavily buying the securities. Loans were also shed by the banks at lower interest rates, so in this way banks have led down billions of dollars of loans. So when property prices went down the borrowers were unable to pay the loan as they couldnt sold the houses as there were either no takers or they suffered heavy losses. So Banks went Bankrupt and the bubble busted. With the development of financial globalization there was huge flow of funds by investors from countries with less interest rate to countries offering high interest rates on investments. So the funds flow by American investors into the emerging markets for better returns and capital flows to other countries. Also the emerging market private players borrowed huge amount of capital investment from US investors. So the effect of 2008 Great depression due to Subprime crisis was not limited to USA alone but its effects can be seen in other parts of the world with crashing stock markets and low economic growth. The decoupling effect that the countries like china and India are insulated from financial developments in USA proved wrong. So it was a mother of all crises whose effects were seen around the world. The Hedge funds suffered a lot due to fall in credits and low investment interests. The depression economics is more to do with the demand side of economics when there are large resources to be utilized but the demand for the resources is not adequate enough which creates recessionary conditions bringing economy to a halt. The Fed of USA increases the demand by increasing the supply of money in the economy by lowering interest rates so the consumption of the people grows and thus demand is augmented in the economy. Although over a short period the supply side economics may rule requiring capacity to increase to meet the demand but over a long time demand side need to be maintained to fully utilize the economical capacity as can be seen during the recessions of SE Asia, Japan and Recent depression. The fed came to the rescue of Mac and Manie by giving a fiscal stimulus of billions of dollars thereby increasing credit flow in the economy and thus increasing the demand from consumer side and businessman. The govt. did not gave packages to Lehmann Brothers as it was not thought to cause any damage but in the end it further dropped the confidence of the investors. There is need to bring the regulatory framework in the non-banking operations of the financial institutions so that the Shadow Banking is barred from taking large risks. At the same time if Insurance covers and reserve money for security had been there with these large financial institutes then they might not had been bankrupted. The capital inflows from various countries also increased the liabilities of the bank to large proportions so when recession is hit the banks are hit through bank Runs. In the end the economic problems are not due to wrong economic structures but are caused by the obsolete doctrines that clutter the minds of the men.