Thursday, August 8, 2013

Paul Krugman on what everyone got wrong about our current financial crisis

In his NY Times blog, Professor Paul Krugman discusses the three major issues that everyone has gotten wrong about our current financial crisis.

All modesty aside, it is publicly documented that I got each of these issues right.

Professor Krugman see these three issues as

a good way to get at the broader question of why recovery has been so sluggish. 
The starting point is that we had a monstrous housing bubble, and Janet Yellen recognized it in real time....
So did I.  So if recognizing a monstrous housing bubble in real time qualifies one to be Fed Chairman, then I am qualified.

It’s important to notice that just being willing to see the obvious here puts Janet Yellen way ahead of a lot of people who still presume to give us advice on the economy. 
But Yellen initially thought the damage from a bursting bubble could be contained, although she was starting to worry by 2007. 
Why was she wrong? Matt emphasizes the financial crisis — the way the bursting bubble created a run on the shadow banking system. And that’s clearly key to understanding the severity of the 2007-9 slump. 
Yes, it is critically important to understand the shadow banking system.

If one understands the shadow banking system you would recognize that we did not have a run.

When investors cannot value a security they are unwilling to lend against it.  To characterize an unwillingness to blindly bet as a run simply shows a lack of understanding of the shadow banking system.

Unfortunately, the economy didn’t come roaring back. Why? 
The best explanation, I think, lies in the debt overhang. For the most part, even those who correctly diagnosed a housing bubble failed to notice or at least to acknowledge the importance of the sharp rise in household debt that accompanied the bubble...
And I would argue that this debt overhang has held back spending...
Your humble blogger recognized the debt overhang and has been saying since the beginning of the financial crisis that banks need to recognize upfront their losses on this excess debt if the real economy is going to emerge from its economic malaise.

It is nice that a Nobel prize winning economist agrees with my analysis.

Finally, nobody really anticipated the disastrous response of policy, above all the squeeze on public spending at a time when we needed more government spending to sustain the economy until private balance sheets were repaired. 
Actually, I anticipated the disastrous policy response.  I even said what was needed as a policy response back in December 2007 before the financial crisis reached an acute stage.

Since then, I have used this blog to explain before a policy is adopted why it will not work to end the current financial crisis.

Given that Professor Krugman has established what it takes to be an expert on our current financial crisis who's opinion should be listened to, I look forward to talking with Professor Krugman and others on what it really will take to end this crisis.

No comments: