Econ Books

164 .

The Return of Depression Economics

Chapter 6, should have served as an object lesson of the dangers

posed by the shadow banking system. Certainly many people were

aware of just how close the system had come to collapse.

But this warning was ignored, and there was no move to extend

regulation. On the contrary, the spirit of the times-and the ideol-

ogy of the George W. Bush administration-was deeply antiregu-

lation. This attitude was symbolized by a photo-op held in 2003,

in which representatives of the various agencies that play roles in

bank oversight used pruning shears and a chainsaw to cut up stacks

of regulations. More concretely, the Bush administration used fed-

eral power, including obscure powers of the Office of the Comp-

troller of the Currency, to block state-level efforts to impose some

oversight on subprime lending.

Meanwhile, the people who should have been worrying about

the fragility of the system were, instead, singing the praises of

"financial innovation." "Not only have individual financial institu-

tions become less vulnerable to shocks from underlying risk fac-

tors," declared Alan Greenspan in 2004, "but also the financial

system as a whole has become more resilient."

So the growing risks of a crisis for the financial system and the

economy as a whole were ignored or dismissed. And the crisis

came.

'II' \1'

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. . 9

THE SUM OF ALL FEARS

On July 19, 2007, the Dow Jones Industrial Average rose above 14,000 for the first time. Two weeks later the

White House released a "fact sheet" boasting about the economy's performance on the Bush administration's watch:

"The President's Pro-Growth Policies Are Helping Keep Our Economy Strong, Flexible, and Dynamic," it declared. What about

the problems already visible in the housing market and in subprime

mortgages? They were "largelycontained," said Treasury Secretary

Henry Paulson in an August 1 speech in Beijing.

On August 9 the French bank BNP Paribas suspended with-

drawals from three of its funds-and the first great financial crisis

of the twenty-first century had begun.

I'm tempted to say that the crisis is like nothing we've ever seen

before. But it might be more accurate to say that it's likeeverything

we've seen b.~~ore,all at once: a bursting real estate bubble com-

Cn'S'> 10 :-.b ~~

~~i~ .-wl , (:I_1'k 1{..CJV.J- ."

~ I I~,~~'

parable to what happened in Japan at the end of the 1980s; a rave 1\'1'U ~ of bank runscomparableto those of the early1930s(albeitma

.

inly \, (~n~\''''''t-'

involving the shadow banking system rather than conventional j.r

banks); a liquidity trap in the United States, again reminisfent.> \;t4d'i\

of Japan; and, most recently,a disruptionof internationalca

~

'tal i»t '

.

"!'

.

flows and a wave of currency crises all too reminiscent of what ap- '

pened to Asia in the late 1990s. ~t..J~!

Let's tell the tale. \ r h 0 M 1'1 , -r"""'\. -t'I\1IJ'i

\ ~'q ;

\ ct.'~Y1-'1+1;';\

166 .Return of Depression Economics

The Housing Bust and Its Fallout

The great U.S. housing boom began to deflate in the fallof 2005-

but it took a while for most people to notice. As prices rose to

the point where purchasing a home became out of reach for many Americans-even with no-down-payment, teaser-rate loans-sales

began to slacken off. There was, as I wrote at the time, a hissing

sound as air began to leak out of the bubble.

Yet housing prices kept rising for a while.Thiswas to be expected.

Houses aren't like stocks, with a single market price that changes

minute by minute. Each house is unique, and sellers expect to wait

a while before actually finding a buyer. As a result, prices tend to be

based on what other houses have sold for in the recent past: sellers

don't start cutting prices until it becomes painfully obvious that

they aren't going to get a full-price offer. In 2005, after an extended

period during which home prices had been rising sharply each year,

sellers expected the trend to continue, so asking prices actually

continued to rise for a while even as sales dropped.

By the late spring of 2006, however, the weakness of the mar-

ket was starting to sink in. Prices began dropping, ,slowlyat first,

then with growing speed. By the second quarter of 2007, accord-

ing to the widely used Case-Shiller home price index, prices were

. THE SUM OF ALL FEARS 167

h,

only down about 3 percent from their peak a year earlier. Over the

course of the next year they fell more than 15 percent. The price

declines were, of course, much larger in the regions that had expe-

rienced the biggest bubbles, like coastal Florida.

Even the gradual initial decline in home prices, however, under-

mined the assumptions on which the boom in subprime lending

was based. Remember, the key rationale for this lending was the

belief that it didn't really matter, from the lender's point of view,

whether the borrower could actually make the mortgage payments:

as long as home prices kept rising, troubled borrowers could always

either refinance or payoff their mortgage by selling the house. As

soon as home prices started falling instead of rising, and houses

became hard to sell, default rates began rising. And at that point

another uglytruth became apparent: f~eclosure isn't hist atr~ged.y fpr the homeowners. it's a lo].1!iYdeal for the Ipnrle.r...Between the

time it takes to get a foreclosed home back on the market, the legal

expenses, the degradation that tends to happen in vacant homes,

and so on, creditors seizing a house from the borrower typically get

back only part, say half, of the original value of the loan.

In that case, you might ask,why not make a deal with the current

homeowner to reduce payments and avoid the costs of foreclosure?

~ W..ell.for one thing, that also costs money, and it requires staff. (J, ~\w. ~

.~~rimc:..loans were not, for the most part, made by banks that held on to the loans; they were made by loan originators, who

quicklysold the loans to financial institutions, which, in turn, sliced

and diced pools of mortgages into collateralized debt obligations

(COOs) sold to investors. The actual management of the loans was

left to loan servicers, who had neither the resources nor, for the

most part, the incentive to engage in loan restructuring. And one

more thing: the complexity of the financial engineering support-

ing subprime lending, which left ownership of mortgages dispersed

168

8 The Return of Depression Economics

among many investors with claims of varying seniority, created for-

midable legal obstacles to any kind of debt forgiveness.

So restructuring was mostly out, leading to costly foreclosures.

And this meant that securities backed by subprime mortgages

turned into very bad investments as soon as the housing boom

began to falter.

The first moment of truth came(early in 2007.' as the trouble

with subprime loans first became appa~t~ Recallthat collater- , (f (),-

!alized debt obligations established a seniority ranking for shares: I 7JI!)'V

owners of the more senior shares, the ones rating agencies declared ~ )

to be AAA, had first dibs on payments, with those holding the less . '

h h '

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I '

b ' .

d .nI c, (Ii ~17y'\"-l

semor s ares, w lC were given ower ratmgs, emg pal 0 yalter I i

the senior-share holders had received their due. Around Febru- ~ S

ary 2007 the realization sank in that the lower-rated shares were ~I.t <1 .'

probably going to take serious losses, and prices of those shares I'~') ','

plunged. This more or l~liSput ~ end to the whoJe P!2.~ess_of ;~- Z subprime lending: because nobody'.~~~ bULthe junior s~[es, f11i

it was no longer possible to repacka e sub rime loa. ,

a!?-tt~n~ncmg lsappeared. This in turn, by removing an important source of housing demand, worsened the housing slump.

Still, for a long time investors believed that the senior shares j).1.......

in those COOs were reasonably well protected. As late as Octo- tr1 L 1. ber 2007, AAA-rated shares in subprime-backed mortgage pools P

were still trading at close to their face value. Eventually,however, it J, 114

Decame clear that nothing related to housing was safe-not senior ;...b1

shares, not even loans made to borrowers with good credit ratings IYWNtw-

who made substantial down payments. fz1lJ:"f Why? Because of the sheer scale ohhe housing bubble. Nation--j::hi

ally,housing was probably overvalued by more than 5(; percent by ~ the summer of 2006, which meant that to eliminate the overvalu- ~~,

'J

ll"8 THE SUM OF ALL FEARS 8 169

ation, prices would have to fall by a third. In some metropolitan

areas, the overvaluation was much worse. In Miami, for example,

home prices appeared to be at least twice as high as the fundamen-

tals could justify. So in some areas prices could be expected to fall by 50 percent or more.

This meant that practically anyone who bought a house dur-

ing the peak bubble years, even if he or she put 20 percent down,

was going to end up with negative equity-with a mortgage worth

more than the house. Indeed, there are probably around 12 million

American homeowners with negative equity as this book goes to

press, And homeowners with negative equity are prime candidates

for default and foreclosure, no matter what their background. For

one thing, some of them may simply choose to "walk away"-to

walk out on their mortgage, figuring that they will end up ahead

financially even after losing the house. It's never been clear how

important a phenomenon walking away really is, but there are

plenty of other routes to default. Job loss, unexpected medical

expenses, divorce-all of these can leave a homeowner unable to

make mortgage payments. And if the house is worth less than the mortgage, there is no way to make the lender whole.

As the severity of the housing bust sank in, it became clear that

lenders would lose a lot of money, and so would the investors who

bought mortgage-backed securities. But whyshould we cry for these

people, as opposed to the homeowners themselves? Mter all, the

end of the housing bubble willprobably,when the final reckoning is

made, have wiped out about $8 trillion of wealth. Of that, around

$1'trillion willhave been losses to homeowners, and only about $1

trillion losses to investors. Why obsess about that $1 trillion?

The answer is, because it has triggered the collapse of the shadow banking system.

170 . Return of Depression Economics

. The Non-Bank Banking Crisis

d

As we've seen, there were some serious financial tremors in the first

half of 2007, but as late as early August the official view was that

the problems posed by the housing slump and subprime loans were

contained-and the strength of the stock market suggested that

markets agreed with the official position. Then, not to put too fine

a point on it, all hell broke loose. What happened?

In Chapter 8 I quoted TIm Geithner of the New York Federal

Reserve Bank about the risks posed by the rise of the shadow

banking system: "The scale of long-term risky and relatively.illiq-

uid assets financed -by;;ry. ~h~rt=termliabilities made many ofthe~- -- _. .- - vehicles and institutions in this paraItel financial system vulnerable- ~_ _. .0- ' _~ _'"",,-

to a classic type of run, but without the protections such as deposit- - - ---=------- insurance that the banking system has in place to reduce such.-- "--

risks." In that same speech, given in June 2008, he described-in

surprisingly vivid language for a central banker-how that run had

actually happened. It began with subprime-related losses, which

undermined confidence in the shadow banking system. And this

led to a vicious cycle of deleveraging:

Once the investors in these financing arrangements-many

conservatively managed money funds-withdrew or threat-

ened to withdraw their funds from these markets, the system

became vulnerable to a self-reinforcing cycle of forced liquida-

tion of assets, which further increased volatility and lowered

prices across a variety of asset classes. In response, margin

requirements were increased, or financing was withdrawn

altogether from some customers, forcing more de-leveraging.

Capital cushions eroded as assets were sold into distressed

markets. The force of this dynamic was exacerbated by the

)' !

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I\i,

.p'

ai

THE SUM OF ALL FEARS .

171

poor quality of assets-particularly mortgage-related assets-

that had been spread across the system. This helps explain

how a relatively small quantity of risky assets was able to

undermine the confidence of investors and other market par-

ticipants across a much broader range of assets and markets.

1'~ "{'~\Il~~ ~'l~~ ~ (}(,>;J ~(lQAlJ' ~ ~~ }y)l" <,(»-20~ . \. ,~ tV \~. ~J.f- n,z,'fI1\'V'-'

Notice Geithner's emphasis on how ~eclininK ,~.s~ r)-r>

da~~d_b~lance_~hee~L Jqrcing further~M.eL$..'!leLin a .self-,I'fr,-{ reinforcing process. This is, at a fundamental level, the same logic(f,.( J'

of deleveraging dlcit led to the self-fulfillingfinancial crises i~,.tfa ..:J1,\~ ,f

in 1997 and 1998, described in Chapter 4. Highly leverage~ play- t T ers in the economic system suffered losses, which forced them into

actions that led to further losses, and so on. In this case the losses J occurred through the collapsingvalue of riskyfinancial assets rather I':>,\\i>'¥.i!

than through the collapsing value of the domestic currency, as in "'i"'"

Indonesiaor Argentina,but the storywasessentiallythe same. '(', h

And the result of this self-reinforcing process was, in effect, a

massive bank run that caused the shadow banking system to shrivel .- ~ )-

up, ~u~~~ the conventional banking system did in the early 1930s. '''''(';' ~~e~ ineffecta bankingsectorproviding$330 bil- \ ~I.

, .I

lion worth of credit, disappeare4. ~se!::!>~~~.!:s!al pae~r, '"" another de facto banking sector,dropped from providing $1.2 trillion 1'\,t 1..,\

in credit to providing only $700 billion.And so on down the ti'ti~~,...l'":r;~1) Crazy things began happening in the financial markets. Interest 0') ,."It"

rates on U.S. Treasury bills-that is, short-term debt-dropped

close to zero. That was because investors were fleeing to safety,

and as one commentator put it, the only things they were willing

to buy were T-billsand bottled water. (U.S. government debt is as

safe as anything on the planet, not because the United States is

the most responsible nation on earth but because a world in which

the U.S. government collapses would be one in which pretty much

172

. The Return of Depression Economics

. everything else collapses too-hence the demand for bottled

water.) On a few occasions the interest rates on T-bills actually

went negative, because they were the only thing people would

accept as collateral in financial deals, and there was a scramble for

the limited available supply.

Some borrowers were able to make up for the collapse of the

shadow banking system by turning back to conventional banks

for credit. One of the seemingly perverse aspects of the crisis I

has been an expansion of bank credit, which has confused some 1 ,1

observers: where's the credit crunch, they ask? But the expansion 111:

of old-fashioned bank lending came nowhere near to making up 12Jl.. 'ji:

for the collapse in shadow banking. . (j.j"r)j;)JI'Nv,

Consumer credit was the last to go, but by October 2008 there ~ :

was growingevidencethat credit cardswere alsoon the chopping f"A1Vky ;~

block,with credit limitscut, moreapplicantsturned down,and the }"

whole ability of American consumers, already feeling nervous, to

charge things being undermined.

All across the economy, some businesses and individuals were

losing access to credit, while others found themselves paying higher

interest rates even as the Federal Reserve was trying to push rates

down. And that brings us to the emergence of a Japan-style trap for

u.s. monetarypolicy.

,Jju' Iii

'n, IJI .j 'I

The Fed Loses Traction

By the time the financial crisis hit, Alan Greenspan was no longer

running the Federal Reserve. In his place-and obliged to deal with

the mess he left behind-was Ben Bernanke, a former economics

professor at Princeton. (Bernanke was head of the Princeton eco-

nomics department before leaving for the Fed, and hired me when

I moved to Princeton from MIT.)

THE SUM OF ALL FEARS . 173

If you had to choose one individual to be in charge of the Fed

during this crisis, that person would be Bernanke. He's a scholar

of the Great Depression. His research on the way the banking cri-

sis intensified the Depression led him to make a major theoretical

contribution to monetary economics, focusing on the role of credit

availability and balance sheet problems in restricting investment

(mumble "Bernanke-Gertler" to a group of economists worriedly

discussing the crisis, and they'll nod their heads knowingly). And

he did extensive research on Japan's troubles in the 1990s. Nobody

was more prepared, intellectually, for the mess we're in.

Yet as the crisis has unfolded, the Bernanke Fed has had a very

hard time achieving any traction on either the financial markets or

the economy as a whole.

The Fed is set up to do two main things: manage interest rates

and, when necessary, provide cash to banks. It manages interest

rates by buying Treasury bills from banks, thereby increasing their

reserves, or sellingT-billsto banks, thereby reducing their reserves.

It provides cash to specific banks in times of need by lending them

money directly. And it has used these tools aggressivelysince the

crisis began. T~e Fed has cut the ~ed~al funds ra!~-=-theover- night rate at which bankS lel.!d'r~e!yes to ~~n~~her, which is

the normal instrument of monetary policy-from 5.25 percent on

the eve of the crisis to just 1 percent at the time of writing. "Total

borrowings of depository institutions from the Federal Reserve,"

a measure of direct lending, have gone from near-zero before the crisis to more than $400 billion.

In normal times, these moves would have led to much easier

credit. A faU in the Federal funds rate normally translates into

reduced interest rates across the spectrum-lower interest rates

on commercial credit, lower interest rates on corporate borrow-

ing, lower mortgage rates. Meanwhile, lending to banks has histori-

174 T.Return of Depression Economics

cally been enough to ease any shortage of liquidity in the financial

system. But these are not normal times, and historical precedents

haven't applied.

The Fed's lack of traction is most apparent when it comes to

riskier borrowers. Most obviously,there aren't any subprime loans

being made now, shutting one whole class of potential home buy- ers out of the market. Businesses without a top credit rating are

paying higher interest rates for short-term credit now than they did

before the crisis, even though the interest rates the Fed controls

have fallen by more than four percentage points. The interest rate

on Baa-rated corporate bonds at the time of writing was above 9

percent, compared with about 6.5 percent before the crisis. Down

the line, the interest rates that matter for spending and investment

decisions have risen or at least failed to fall, in spite of the Fed's

attempt to drive rates down.

Even prime mortgage borrowers have been hit: the thirty-

year mortgage rate is still roughly where it was in the summer of 2007. That's because the crisis in the financial system more or less

knocked private lenders out of the market, leaving only Fannie

Mae and Freddie Mac, the government-sponsored lenders, still

in business. And Fannie and Freddie found themselves in trouble

too: they hadn't made as many bad loans as the private sector, but

they had made some, and they had very thin capital bases. In Sep-

tember 2008 the federal government took control of Fannie and

Freddie, which should have eased concerns about their debt and

reduced mortgage rates. But the Bush administration made a point

of denying that Fannie/Freddie debt was backed by the full faith of

the U.S. government, so that even after nationalization they con-

tinued to have trouble raising funds.

What about all the loans the Federal Reserve made to the banks?. They have probably helped, but not as much as one might have

~ ,I

i~~~~ t: . THE SUM OF ALL FEARS 175

- 0 ,,."'..0 'riJ:. I:X ..J 1- -.\ 'I . \ , I 7 .., /G1I'\' \.;<0.. I ""_v_ '0 l~ lD K\~ .::r-:'i'1t\0 CO"1\,\J{',\~'0-" llQ t>«\\(<, -,. 'if, ~.1.. 7W~- ,.

d b . Ib ks ' h LI/t\lJ¥' f .fj.;50rt1,li 1.]

expecte , ecause convenbona an aren t at t e Ilean 0 the cn- ., ... tf k"')

S18.Here s an example: If aucbon-rate secunty arrangements had

been part of the conventional banking system, the issuers would

have been able to borrow from the Fed when too few private inves-

tors showed up at the auctions; as a result, the auctions wouldn't

have failed and the sector wouldn't have collapsed. Because they weren't part of conventional banks, however, the auctions did fail

and the sector did collapse, and no amount of Fed loans to Citi-

bank or Bank of America could do anything to halt the process.

In effect, then, the Fed found itself presiding over a Japan-style

liquidity trap, in which conventional monetary policy had lost all

traction over the real economy. True, the Fed funds rate hadn't

been cut all the way to zero, but there was little reason to think that

cutting one more percentage point would have much impact.

What else could the Fed do? In 2004, in scholarly work, Ber-

nanke had argued that monetary policy could be effective, even

" in a liquidity trap, if one were willing to "alter the composition of

~[) the central bank's balance sheet." Instead of only holding Treasury

..lkO~~ bills and loans to conventional banks, the Fed could make loans

~ to other players: investment banks, money-market funds, maybe ~~':L even nonfinancial businesses. And over the course of 2008 the Fed

~\ V1, introduced an alphabet soup of special lending "facilities" to do

'\,\";&11\1111\-just that: the TSLF, the PDCF, and so on. In October 2008 the .'IJi'<<"I'! Fed announced that it would begin buying commercial paper too,

IN\'1'Oy01l,I.,tin effect proposing to do the lending the private financial system

~,,} wouldn't or couldn't do. .~1'\3~ It remains possible, at the time of writing, that these schemes

will eventually bear fruit. What one has to say, however, is that

their effects so far have been disappointing. Why? I'd argue that

the problem is one of substitution and scale. When the Fed acts

to increase the quantity of bank reserves, it's doing something no

176

. The Return of Depression Economics

other institution can do: only the Fed can create monetary base, which can be used as cash in circulation or held as bank reserves.

Furthermore, its actions tend to be large relative to the scale of

the asset classes involved, since the monetary base is "only" $800

billion. When the Fed tries to support the credit market more

broadly, by contrast, it's doing something private actors also d~

which means that the credit it pumps into the system may be partly

offset by private withdrawals-and it's also trying to move a much

bigger beast, the $50 trillion or so credit market.

The Bernanke Fed has also suffered from the problem of being,

again and again, behind the curve. The financial crisis keeps devel-

oping new dimensions, which fewpeople-including the verysmart

people at the Fed-see coming. And that brings me to the interna- tional dimension of the crisis.

The Mother of All Currency Crises

Mter the financial crises of 1997 and 1998, the governments of

the affected countries tried to protect themselves against a repeat

performance. They avoided the foreign borrowing that had made

them vulnerable to a cutoff of overseas funding. They built up huge

war chests of dollars and euros, which were supposed to proted

them in the event of any future emergency. And the conventional

wisdom was that the "emerging markets"-Brazil, Russia, India,

China, and a host of smaller economies, including the victims of

the 1997 crisis-were now "decoupled" from the United States,

able to keep growing despite the mess in America. "Decoupling

is no myth," Tbe Economist assured its readers back in March.

"Indeed, it may yet save the world economy."

Unfortunately, that doesn't seem likely. On the contrary, says

Stephen Jen, the chief currency strategist at Morgan Stanley, the

,

.

'

.8 \

.

(! .THE SUM OF ALL FEARS 177

.a'

"hard landing" in emerging markets may become the "second epi-

center" df the global crisis (U.S. financial markets were the first).

What happened? Alongside the growth of the shadow banking

system, there was another transformation in the character of the

financial system over the past fifteen years, with much of it taking

place after the Asian crisis-namely, the rise of financial globaliza-

tion, with. investors in each co~ntIT hold_Y;~IC!igcLst~~ ~9ili;;" countries. In 1996, on the eve of the Asian crisis, the United States~.._- had assets overseas equal to 52 percent of GDP, and liabilities

~~'r,(,;,\ul.Qequal to 57 percent of GDP. By 2007, these numbers were up to

~J(l\Y~ 128 percent and 145 percent, respectively.The United States had moved deeper into net debtor status; but the net is less impressive

,(~ thanthe vast increase in cross-holdings.

~l.ftJ t. t Likemuch of what happened to the financial system overthe past

:/7\~ decade or two, this change was supposed to reduce risk: because

C;S{~ ') U.S. investors held much of their wealth abroad, they were less exposed to a slump in America, and because foreign investors held

I much of their wealth in the United States, they were less exposed

~ to a slump overseas. But a large part of the increase in financial

5~ d.-1 globalization actually came from the investments of highly lever-

Ll..:x ~"'1~aged financial institutions, whic~ were making various sorts _ of {,W¥; -risky cross-border bets. And when things went wrong in the United

i1c'7+ _ States, these cross-border investments acted as what economists.~ ,\,h ,&,\ '; II " .. h ,,, 11

' , , th d

' th

_ . . _ -'s;: ca a transmlsslonmec amsm, a owmg a cnsls at starte WI :t:l~J~':a.- the U.S. ho~sing market to drive fresh rounds of crises overseas,

~~k:. The failure of hedge funds associated with a French bank is gener-

.f~~ h~1l. ally considered to have marked the beginning of the crisis; by the

~D';\( t fall of 2008, the troubles of housing loans in places like Florida had{.~ destroyed the banking system of Iceland. \

v In the case of the emerging markets, there was a special point '7V; (M!rQ f I b

' I' h II

d~

'-"

d\ Th'

t d ' I b' 0 vu nera Ilty, t e so-ca e carry trae. IS ra e mvo ves or-

4 DS ~ ()T\ k 60Ji (J~J; I ~ ~ ~ Cvu~~k. I~ Il~''tl b() i)~l~) 1/J\ hJ,"\,,)\.,~.\ '

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.Return of Depression Economics

~ G:\\~ i1b ~~i't rowingin countrieswith lowinterest rates, especiallybut not only'f 1(..,0- --

Japan, and lending in places with high interest rates, like Brazil lQ. and Russia. It was a highly profitable trade as long as nothing went fVZ'1'

wrong; but eventually something did. ( 1'8Lt,\!..i..III

The triggering event seems to have been the fall of Lehman'1 i\ fu.

Brothers, the investment bank, on September 15, 2008. When tij/b ~'i~ Bear Stearns, another of the original five major investment banks, _ I .J-

. ( f:l 'Ii

ili.J.fN.'\Zj

got in trouble in March 2008, the Fed and the Treasmymoved in-

not to rescue the firm, which disappeared, but to protect the firm's

"counterparties," those to whom it owed money or with whom

it had made financial deals. There was a widespread expectation

that Lehman would receive the same treatment. But the Treasury

Department decided that the consequences of a Lehman failure

would not be too severe, and allowed the firm to go under without

any protection for its counterparties.

Within days it was clear that this had been a disastrous move:

confidence plunged further, asset prices fell off another cliff,.and

the few remaining working channels of credit dried up. The effec-

tive nationalization of AIG, the giant insurer, a few days l.ater,failed

to stem the panic. And one of the casualties of the latest round of panic was

the carry trade. The conduit of funds from Japan and other low-\,

interest nations was cut off, leading to a round of self-reinforcingl.----

effects all too familiar from the crisis of 1997. Because capital

was no longer flowing out of Japan, the value of the yen soared;

because capital was no longer flowing into emerging markets, the

value of emerging-market currencies plunged. This led to large~. _. ...

capital losses for whoever had borrowed in one currency and lent

in another. In some cases that meant hedge funds~and the hedge

fund industry, which had held up better than expected until the

demise of Lehman Brothers, began shrinking rapidly. In other cases

178

"'

p

~' :Ii

THE SUM OF ALL FEARS . 179

it meant firms in emerging markets, which had borrowed cheaply

abroad, suddenly faced big losses.

For it turned out that the efforts of emerging-market govern-

ments to protect themselves against another crisis had been undone

by the private sector's obliviousness to risk. In Russia, for example,

banks and corporations rushed to borrow abroad because foreign

interest rates were lower than ruble rates. So while the Russian

government was accumulating an impressive $560 billion hoard of

foreign exchange, Russian corporations and banks were running

up an almost equally impressive $460 billion foreign debt. Then,

suddenly, these corporations and banks found their credit lines

cut off, and the ruble value of their debts surging. And nobody

was safe: for example, major Brazilian banks avoided taking on a large foreign exposure but nonetheless found themselves in trouble

because their domestic clients hadn't been equally careful.

It all bore a strong resemblance to previous currency crises-

Indonesia 1997, Argentina 2002. But it was on a far larger scale.

This, truly, is the mother of all currency crises, and it represents a

fresh disaster for the world's financial system.

A Global Slump

Most of this chapter has been taken up with the financial aspects

of the crisis. What does all this portend for the "real economy," the

economy of jobs, wages, and production? Nothing good.

The United States, Britain, Spain, and several other countries

probably would have suffered recessions when their housing bub-

bles burst even if the financial system hadn't broken down. Falling

home prices have a direct negative effect on employment through

the decline in construction, and they tend to lead to reduced con-

sumer spending because consumers feel poorer and lose access to

180 .

The Return of Depression Economics \1.8

home equity loans; these negatives have a multiplier effect as fall-

ing employment leads to further declines in spending. That said,

the U.S. economy actually held up fairlywell at first in the face of

the housing bust, mainly because the weakness of the dollar led to

rising exports, which helped offset the decline in construction.

But the financial collapse seems certain to turn what might have

been a run-of-the-mill recession-the U.S. employment rate began

to drop at the end of 2007, but until September 2008 the decline

was fairly modest-into something much, much worse. The inten-

sification of the credit crisis after the fall of Lehman Brothers, the

sudden crisis in emerging markets, a collapse in consumer confi-

dence as the scale of the financial mess hit the headlines, all point

to the worst recession in the United States, and in the world as a

whole, since the early 1980s.And many economists willbe relieved

if it's only that bad.

And what's 1"eallyworrying is the loss of policy traction. The

recession of 1981-82, which drove the unemployment rate above

10 percent, was a terrible thing, but it was also more or less a

deliberate choice: the Fed pursued a tight-money policy to break

the back of inflation, and as soon as Fed Chairman Paul Volcker

decided the economy had suffered enough, he undid the screws,

and the economy came roaring back. Economic devastation turned

into "morning in America" with startling speed.

This time, by contrast, the economy is stalling despite repeated

eHorts by policymakers to get it going again. This policy helpless-

ness is reminiscent of Japan in the 1990s. It's also reminiscent of

the 1930s. We're not in a depression now, and despite everything, I

don't think we're heading into one (although I'm not as sure of that

as I'd like to be). We are, however, well into the realm of depression economics.

. 10

THE RETURN OF

DEPRESSION ECONOMICS

The world economy isnot in depression; it probably won't fall

into depression, despite the magnitude of the current cri-

sis (although I wish I was completely sure about that). But

while depression itselfhas not returned, depression economics-the

kinds of problems that characterized much of the world economy

in the 1930s but have not been seen since-has staged a stunning

comeback. Fifteen years ago hardly anybody thought that modem

nations would be forced to endure bone-crushing recessions for fear

of currency speculators, and that major advanced nations would

find themselves persistently unable to generate enough spending to

keep their workers and factories employed. The world economy has

turned out to be a much more dangerous place than we imagined.

How did the world become this dangerous? More important, how do we get out of the current crisis, and what can we do to