Krugman's New Depression

I've just been reading an interesting article by Paul Krugman regarding the New Depression and thought I would share a condensed version.

He starts by looking at the deflation of the housing market in autumn 2005, and the late realisation of this in the spring of 2006. It seems that although house values were deteriorating and sales were falling, actual prices were not.

Of course this is fairly damaging, because as soon as home owners find themselves in a negative equity situation, creditors feel the pressure. Foreclosures are a poor conduit of debt recovery.

He then talks on why the creditors don't help out the home owners by relaxing payment plans or "restructuring" their debt. It becomes apparent that this debt is actually sold on and divided up between investors and other parties of something known as a shadow banking system. These mangled debts are branded collateralised debt obligations or CDOs, the management of which falls down to loan servicers who have little interest or resources to enable debt restructuring.

In essense by this stage, securities backed by sub-prime mortgages became a bad investment. By Febuary 2007, it was realised that shares in CDOs were going to take a serious hit... in fact by the end of 2007, it was generally decided that anything to do with the housing marked was pretty dangerous.

It turns out that the dessolation of the housing market saw $8 trillion in losses, $7 trill of which were felt by home owners, $1 trill of which by investors. You would have naturally thought the knock on effect to home owners would be the worst felt, however that $1 trill loss to investors actually triggered the colapse of the shadow banking system.

In a nutshell, the shadow banking system has become very popular due to high interest rates and low borrowing rates... but at a cost of deregulation and lack of Federal assurance. The SBS could do this because it did not require the level of liquidity that the banking system mandated.

So what happened? Well simply put, people panicked and started to try and repay debts by selling assets. In essence, it became a run on the banks similar to those of the 30s, with the exception that this was a run of mouse clicks... but just as damaging.

US investment banks started falling and the Fed tried to help by lowering interest rates, but this was only felt by business and individuals with top credit ratings... those with poor ratings were still being charged higher rates, so the cuts were not felt as widely as the Fed had hoped.

Of course the other danger of the SBS was that the Fed seemed powerless to help; pouring money into the banking system generally did nothing to quell the pain perpretrated by the SBS. It was decided then, that the way to help the shadow banking system was to invest in investment banks, money market funds and even non-financials.

See, helping the banking system encompassing just $800bn was a pretty easy task... but of course the SBS was playing with around $50 trill of credit, so any rescue package would just be a drop in the ocean.


Now we talk about decoupling. Krugman talks about the way our global ecomomy is, on paper, able to decouple itself from the US and Europe when needed, therefore warding against a global recession. The problem with decoupling seems to be twofold. Firstly, emerging markets were heavily investing in the US as a means of stability; secondly US and global investment banks were taking part in a mechanism know as the carry trade. Simply put, an entity borrows from an economy with low interest rates, and lends to economies with high rates. When it works... it works well. The only backlash being of course, that global economies are therefore very much intertwined as a result.

The core issue along with the aforementioned is the lack of demand as the result of financial insecurity coupled with bloated production capacity. A bad combination indeed. Simply put, private spending is drying up.

So what is the solution? Recapitalisation, some of which is already taking place in the form of the Fed's $700bn bailout package, but Krugman believes that this is too little, and that a broader recapitalisation is required, and maybe even deeper nationalisation of key financial entities and processes.

He concludes by talking about the apparent need for deeper and deeper regulation to these entities, processes and systems once recovered to prevent reoccurance. These safeguards were already put in place in the aftermath of the Great Depression, but it seems that as the Great Depression became that of fairy tales... people became more comfortable with the idea of an indestructable, infallable financial system and became lax, dangerously opportunistic and more demanding of what is in reality, a very fragile system.

Krugman's article made for some interesting reading not only because it explored the past, present and future of the current crisis, but because it went some way into understanding why the "infection" so to speak was able to masasticise so quickly throughout the financial systems of the world both developing and developed.

He concludes that the real danger here is not lack of resources or even virtue, but of understanding.