Understanding depressions

Business Today

In 1999, Paul Krugman wrote a slim book called The Return of Depression Economics which was mainly in response to the Asian crisis of the '90s. In it, he warned of another 1930s-style depression, but the book attracted little attention. Back then, the US economy and stock market were booming, Fed Chairman Alan Greenspan was hailed as a prodigy and monetarist Milton Friedman remained the patron saint of a staunchly government-free economy.

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Today, the American economy and the world's lies in tatters. Greenspan's name is mud. And instead of Friedman, the world is now listening closely to the ghost of John Maynard Keynes who, over seventy years ago, advocated government spending to boost employment and growth, especially as an antidote to the depression of 1931. Krugman, of course, won the Nobel prize for Economics last year.

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In Krugman's re-tooled book, we are taken on a dizzying voyage across the seas of economic turbulence, confronting the many shortterm and prolonged depressions over time. These include Mexico's 'Tequila' crisis in the '90s, several severe slumps in Argentina over the decades, Japan's growth problems in the '90s, the Asian meltdown and finally the sub-prime crisis. So, why read this book now? After all, isn't much of what transpired over the years painfully familiar to us?

Here's why. What Krugman does is to analyse rather than recount modern depressions and finds that they all share scary traits. Take the Asian meltdown, for example. Excess credit and crony capitalism resulted in the Thai baht going into a free-fall, losing 50 per cent of its value in a flash, causing a contagion across the region. A big problem was an acute crisis of confidence amongst Thais, causing them to spend less, further worsening the economic slump. This is precisely what is taking place in the global economy today.

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Krugman says that Japan, in the '90s, experienced a major 'liquidity trap.' Sounds familiar? It should, since this too is what currently ails much of the world. Japan's economy grew, but not fast enough to keep up with expanding capacity. As a result, its workers and machines both lay idle. Japanese consumers also became reluctant to spend, even at zero interest rates, worsening the recession.

Japan's experiences get to the heart of Krugman's 'Depression Economics' a term he coined to describe the economic mess in the 1930s, which has an uncanny resemblance to today's situation. In essence, monetary policy becomes defunct when you cannot slash rates any further. The only way out is through aggressive financial intervention by the government. This is done by employing people anathema to free-market monetarists of Friedman's ilk so they can buy things and drive business growth.

Krugman points to another leitmotif: leverage, and the havoc it creates. Consider the panic of 1907. People invested a ton of money in unregulated trusts. When one trust failed and panic spread, everyone stampeded out of the market, confidence tanked and so did the economy. In the last few decades of unparalleled economic prosperity, the US blithely ignored much-needed regulation, allowing a highly leveraged 'shadow banking' system to thrive and then spectacularly fail plunging the world into a severe recession.

Undoubtedly, astute economic policies can resuscitate the global economy in a few years. However, if Krugman is right, no one will remember any of the lessons from the current crisis a few decades from now, and that is just plain depressing, if not dangerous.

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