Paul Krugman’s book, The Return of Depression Economics and the Crisis of 2008 is a well-written and thoughtful book relating our current economic crisis to those of the past.
Krugman comments that our current economic crisis is “like everything we’ve seen before, all at once: a bursting real estate bubble comparable to what happened in Japan […] a wave of bank runs comparable to those of the early 1930s, a liquidity trap in the United States, again reminiscent of Japan; and, most recently, a disruption of international capital flows and a wave of currency crises all too reminiscent of what happened to Asia in the late 1990s” (165). I agree with his comments here, as it appears that we can in fact relate our current crisis to those that have befallen the world in the past. History, it is said, does repeat itself.
The Nobel Prize winning economist includes a flowchart in his book detailing what he refers to as “the vicious cycle of financial crisis” (Krugman 90). This chart has three separate sections that are dependent on each other. The first part is the loss of consumer confidence, which leads to the second part, a slumping economy and that culminates in financial problems for companies, banks and household, before leading back to additional loss of consumer confidence. I agree with Krugman’s assessment of said vicious cycle, but I think, more often than not, it does not start at the first part, the loss of consumer confidence, but rather at other parts of the cycle.
Krugman believes that a loss of consumer confidence is typically best displayed in an economic panic, or a sudden fear of economic downfall, which leads to falling stock prices and potential bank runs. According to Krugman, there are two types of economic panics; the first type of panic is “an irrational reaction on the part of investors that is not justified by the actual news” (Krugman 89), which Krugman feels is best emphasized by the temporary fall of the dollar in 1981 after President Ronald Reagan was wounded by a gunmen in an assassination attempt. Because the assassination attempt had nothing to do with the economic state of America, the dollar quickly stabilized. This kind of panic is not permanent, because it is unfounded and often has nothing to do with the real state of the economy.
According to Krugman, the other kind of financial panic is the kind that beset Thailand in 1997. This kind of panic becomes validated after it ensues because “the panic itself makes panic justified” (Krugman 89). It occurs when an initial panic drives an economy into a weaker state, thus ensuring more panicking. Such a panic fell upon Thailand because of the weakness of its neighboring nations; “the currency of its neighbor Malaysia had […] been battered, and the Indonesian rupiah had depreciated about 30%” (Krugman 92). Typically, investors figure that one nation starts to economically suffer; its neighboring countries will follow in its footsteps. “It did not matter that [the economies of Thailand and its neighbors] were only modestly linked in terms of physical flows of goods. They were linked in the minds of investors, who regarded the troubles of one Asian economy as bad news about the others; and when an economy is vulnerable to self-validating panic, believing makes it so” (Krugman 94).
While I agree with Krugman’s point that our current financial crisis is similar to others that have occurred in the past, as well as his belief in the vicious cycle of financial crisis, I disagree with his idea that there are only two types of financial panics, the irrational reaction, and the self-fulfilling panic. I think that the current economic panic is neither of those two. Sure, the panic may have been deepened by the earliest panicers, however, what really caused the panic, and the bursting of the bubble, was severe problems in the economic system. Buyers and sellers relied too much on credit, and when banks made too many bad loans, the unpaid loans amounted to large enough sums to kill banks and require government bailouts. It appears to me that the start of our current financial crisis was not poor consumer confidence, rather it was the third part of the vicious cycle, financial problems for companies, banks, and households, due in large part to both the credit crunch and the housing bubble, that led back to a lack of consumer confidence, and then towards the slumping economy, and then back to even more financial problems for companies, banks and household, thus continuing said vicious cycle.
Krugman recommends that we get credit flowing and that we prop up spending in order to ease the affects of the recession, and start to edge out of it. While I agree with Krugman, we must realize that flowing credit is what got us into this mess. It is not a simple case of unsubstantiated consumer fear; too many people took out far more credit than they should. We should only start to get more credit flowing if we can somehow ensure that people only spend as much on credit as they can pay back, or else we will enter another credit bubble. I also think that we must understand where we put our government spending. We should only put it into places that can help the economy the most, not just pork and unnecessary projects, such as what has been included in the stimulus bills passed by Congress. Krugman has some good ideas relating about how we got into our current financial mess, and how to get out of it, but we must take his ideas with a grain of salt, and apply reason to his remarks.