The Recent Clusterfuck and the Ongoing Unpleasantness

DeLong has some thoughts on the recent crisis and slump here and here.

It's too bad more bloggers haven't engaged Robin Wells and Paul Krugman's "The Slump Goes On: Why?", their article in the New York Review of Books.  Maybe they are waiting for the second part. There were some comments at Krugman's New York Times Blog.

I summed it up here. Here, I focused on the books and authors Wells and Krugman were ostensibly critiquing.

This time I'll focus on the way they structured the article. There's a prologue of sorts and then two sections or parts set off by the numbers 1. and 2. Section 1 is broken up by subheadings. Wells and Krugman use an international context which is helpful in combating erroneous ideas.

The prologue explains what they're doing and what their general thoughts are on the matter. What caused the financial panic and tight credit was the bursting of the housing bubble. The first four headings under Part 1 are each of the popular explanations. Three of them are wrong, one is correct.

1) Loose monetary policy: the Fed held rates too low for too long in the past decade. Wells and Krugman point out that this is wrong. The Fed was responding to a slowdown at the beginning of the decade and there was a housing bubble in Britain, Spain, and Ireland as well. The European Central Bank didn't follow a loose policy as the Fed did.

2) The global savings glut. Wells and Krugman believe this is correct and helps explain the fact that the bubble wasn't contained to just the United States. Bernanke gave a speech in 2005 outlining the ideas behind the concept of the global savings glut.Wells and Krugman write:

Historically, developing countries have run trade deficits with advanced countries as they buy machinery and other capital goods in order to raise their level of economic development. In the wake of the financial crisis that struck Asia in 1997-1998, this usual practice was turned on its head: developing economies in Asia and the Middle East ran large trade surpluses with advanced countries in order to accumulate large hoards of foreign assets as insurance against another financial crisis.

Germany also contributed to this global imbalance by running large trade surpluses with the rest of Europe in order to finance reunification and its rapidly aging population. In China, whose trade surplus accounts for most of the US trade deficit, the desire to protect against a possible financial crisis has morphed into a policy in which the currency is kept undervalued, which benefits politically connected export industries, often at the expense of the general working population.

For the trade deficit countries like the United States, Spain, and Britain, the flip side of the trade imbalance is large inflows of capital as countries with surpluses bought vast quantities of American, Spanish, and British bonds and other assets. These capital inflows also drove down interest rates--not the short-term rates set by central bank policy, but longer-term rates, which are the ones that matter for spending and for housing prices and are set by the bond markets. In both the United States and the European nations, long-term interest rates fell dramatically after 2000, and remained low even as the Federal Reserve began raising its short-term policy rate. At the time, Alan Greenspan called this divergence the bond market "conundrum," but it’s perfectly comprehensible given the international forces at work.

Bernanke noticed the conundrum too, but both he and Greenspan missed the housing bubble.  Maybe the "conundrum" was a sign?

3) Out of control financial innovation. Wells and Krugman don't believe this was essential because it wasn't as bad in Europe, which suffered similarly. However I would guess that the financial gimmickery helped disguise what was going on and helped the ratings agencies become complacent. Also this seems to be tied in with Minsky's theories which they discuss at the end of the article.

4) Moral hazard created by the GSEs. Wells and Krugman dismiss the common arguments of conservatives by pointing out that private actors like Countrywide Financial and negligent regulators created the subprime fiasco. Fannie and Freddie were latecomers.

The fifth subheading of section one is titled "The Bubble as a White Swan" and points out that bubbles are more common than one would guess, given the way almost everyone missed the most recent bubble.

In Section/Part 2, they discuss Minsky's theories about how in periods of stability people become less risk averse and how after a bubble bursts you can get a "balance sheet recession." This didn't happen with the tech stock bubble at the end of the 1990s, but it did happen with the real estate bubble in Japan with non-financial corporations and it did happen most recently with American household debt and the decline in housing prices.

In the next article, Wells and Krugman will discuss what needs to be done.