Literary Insights

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Here is a summary of the praise for Paul Krugman’s book “The Return of Depression Economics and the Crisis of 2008”:

It is praised for its ability to explain very complex economic concepts in a clear and engaging way that makes the reader feel smarter. Krugman has a gift for simplifying complexity.
Reviewers say Krugman is the best writer on economics and the world’s most famous economist. He has an unparalleled ability to analyze economic history and current events.
The book is called brilliant and thought-provoking. It provides an excellent and well-written account of economic booms and busts over the past several decades.
Critics say Krugman shows why conventional economic theories failed during crises and that he pokes holes in theories that don’t fit reality. His work helps improve understanding of economic history.
The book is praised as a call to action that helps explain how crises like the one in 2008 could happen. It aims to help develop new ways of thinking about economic problems.
Reviews commend Krugman’s ability to combine analysis of arcane details with large, unified explanations in an accessible way without jargon or complex models.

So in summary, the book receives high praise for Krugman’s clarity in explaining economic concepts, his ability to analyze and synthesize history, and for questioning orthodox theories in a way that remains engaging and thought-provoking for readers.

In the early 2000s, prominent economists like Robert Lucas declared that the “central problem of depression-prevention” had been solved due to modern macroeconomic policies reducing business cycle volatility. However, this view seemed overly optimistic in hindsight given the 2008 financial crisis.
In the 1990s, conditions were positive for market economics and capitalism. China had embraced capitalism in 1978. The collapse of the Soviet Union in 1991 eliminated socialism as a viable alternative ideology on the world stage. Former Soviet bloc countries transitioned to market economies, though this was a challenging process for many.
The fall of the USSR also deprived communist regimes like Cuba of Soviet support, undermining their legitimacy. Overall, the geopolitical environment heavily favored capitalism in the decades following the Cold War’s end. However, economic problems in countries like Japan in the 1990s showed depression-type difficulties could still emerge, despite optimistic claims about business cycles being solved.
The collapse of the Soviet Union severely undermined socialist movements and ideals around the world. Places like Cuba, North Korea and radical leftist terrorist groups in Europe depended heavily on Soviet funding and support. Without this backing, their revolutionary stances lost credibility and viability.
The failure of real-world socialist experiments in the USSR and China destroyed the appeal of socialism as a serious political-economic alternative to capitalism. It became much harder to advocate for socialism with a straight face after its failures and atrocities were exposed.
For the first time since 1917, capitalism is now the dominant and unchallenged system globally. It faces less ideological opposition and skepticism thanks to the discrediting of socialism. However, this hegemony may not last forever as economic crises could breed new anti-capitalist ideologies.
The story of the “Capitol Hill Baby-sitting Co-op Crisis” is used to analogously explain how recessions can occur. Too few coupons in circulation within the cooperative economy led to a reluctance to participate that created a self-reinforcing recession at a small scale. This story serves as an “intuition pump” to understand recessions on a larger scale.
The passage uses the example of a baby-sitting co-op to illustrate how recessions can occur due to a lack of “effective demand” - when members try to save coupons rather than spend them on baby-sitting. This shows how recessions may be due to monetary issues rather than structural economic problems.
It notes that the co-op’s recession was resolved by increasing the supply of coupons, demonstrating that recessions can sometimes be fixed relatively easily through monetary policy like money printing.
Central banks aim to prevent recessions through monetary intervention, but before WWII their understanding was limited. Now it is recognized that money injections can fight recessions caused by demand shortfalls. However, excessive money creation can also cause inflation.
By the 1980s, central banks like the Fed were getting better at regulating the economy and recessions became milder. New technologies also made the economy seem more stable and prosperous through the late 90s. However, risks remain from factors like oil prices, central banks misjudging inflation, and external shocks.

So in summary, the passage uses the co-op example to illustrate how recessions may have monetary rather than structural causes, and how monetary policy interventions can help address them, though macroeconomic management remains a challenge. It traces the evolution of thinking on these issues over the 20th century.

In the post-WWII era, large corporations dominated capitalism and entrepreneurship declined. Business was seen as bureaucratic and not very exciting.
The rise of the information industry in the late 20th century renewed interest in entrepreneurship and free markets. Figures like Steve Jobs and Bill Gates were seen as innovative individuals who achieved success through their ideas.
Globalization helped spread prosperity beyond just advanced nations. As countries like Indonesia and Bangladesh joined global trade networks, their economies grew and living standards rose significantly due to manufacturing and export-led growth. Wages rose and poverty declined substantially in places that embraced globalization.
While globalization clearly improved life for many in the developing world, some criticized the poor working conditions and exploitation of labor. There were also concerns that wealth was not evenly distributed and some groups were left behind by economic changes. Critics argued globalization did not help places like Africa enough and more efforts were needed to spread the benefits more widely.
In the 1980s and early 1990s, Latin America underwent significant economic reforms, adopting policies like privatization, trade liberalization, budget cuts, and inflation control in an effort to stabilize their economies after decades of crises.
Mexico in particular reformed, cutting tariffs, selling state-owned companies, and loosening rules on foreign investment and ownership. Carlos Salinas succeeded Miguel de la Madrid as president, representing a new generation of reformist technocrats educated abroad.
These reforms seemed to be working, as Latin American countries attracted large capital inflows and their economies grew rapidly in the late 1980s and early 1990s. However, warnings signs were largely ignored.
In 1994, Mexico suffered a severe financial crisis known as the “tequila crisis,” plunging the country into recession. This crisis spread across Latin America and showed that the positive market views could change quickly, despite reforms. However, the warning of this crisis going unheeded in the years leading up to it.

So in summary, while Latin America underwent substantial economic reforms in the 1980s-1990s, the crises those reforms were intended to avoid returned in 1994 in Mexico, though the warnings signs had been downplayed in the preceding years.

In the late 19th/early 20th century, Argentina was considered wealthy and integrated into the global economy through agriculture exports, investment, and infrastructure like railways. It had a strong economy and was a popular destination for European immigrants.
The 1920s-30s were difficult due to falling commodity prices and debt burdens. Argentina struggled more than advanced nations but recovered better than expected in the 1930s using devaluation, capital controls, and debt moratoriums. However, this established interventionist policies that discouraged private sector growth.
By the 1980s, inefficient state enterprises, import barriers, debt, inflation, and the Falklands War crisis had severely damaged the economy. The hyperinflation of the late 1980s led to the election of Carlos Menem and radical market reforms under his finance minister Domingo Cavallo in the early 1990s, including trade opening, privatization, and fiscal tightening. This broke with Argentina’s past interventionist policies and history of economic decline.

The reforms Argentina implemented under Cavallo, including enacting a currency board that pegged the peso to the dollar at a fixed 1:1 exchange rate, were extremely effective at curbing inflation. Inflation rapidly dropped to near zero levels. The economy also saw strong growth, with GDP increasing by 25% in just three years after years of decline. However, some economists questioned whether the exchange rates in both Argentina and Mexico had become overvalued, as inflation in both countries continued to outpace the U.S. for a couple years after stabilization. Mexico in particular ran large and growing trade deficits as imports surged due to import liberalization and easy credit, even as export growth remained sluggish because of the strong peso. Despite massive capital inflows, Mexico’s economic growth remained disappointing and barely outpaced population growth, raising questions about what was preventing the country from realizing more benefits from its reforms and investments.

Here is a summary of the key points about the Tequila Crisis:

In December 1994, Mexico was facing a steady loss of foreign exchange reserves and had to decide whether to raise interest rates or devalue the peso. It chose to devalue the peso by 15%, hoping to boost exports and attract foreign investment.
However, Mexico botched the devaluation. It was not large enough, as economists recommended, and Mexican officials did not adequately reassure foreign investors. This led to massive capital flight.
The peso plunged in value, losses on dollar-linked government bonds (tesobonos) exploded, and Mexico faced a severe fiscal crisis with ballooning interest rates on its debt.
The economic crisis spilled over into the private sector, with GDP declining 7% in 1995 and industrial production falling 15%. Thousands of businesses failed and hundreds of thousands lost jobs.
In a phenomenon called the “tequila effect,” the crisis spread beyond Mexico to other countries like Argentina through contagion among investors. Argentina faced a banking crisis despite its currency board system.
Mexico and Argentina desperately needed international bailouts, especially with dollars, to stabilize their economies and currencies. The U.S. eventually provided emergency funding despite political opposition.
After the 1995 “tequila crisis” in Mexico, both Mexico and Argentina recovered rapidly within a few years, leading many to draw the wrong lessons. They saw Mexico’s issues as unique and not applicable elsewhere.
They credited the IMF and US Treasury with quickly containing the crisis, but the response involved legal maneuvering and success relied partly on luck. It may not have worked as well in future crises.
Japan’s lost decade(s) of economic stagnation in the 1990s-2000s went largely ignored, despite the lessons it held. As the #2 economy, Japan’s troubles showed crises were not limited to smaller economies.
In the 1980s, Japan had experienced miraculous post-WWII growth and became a major economic power. However, from the early 1990s onward it struggled with recessions and failed to kickstart sustainable growth again, despite its advantages like educated workforce, technology, and domestic market.
Both Mexico’s crisis and Japan’s lost decades were warning signs of the vulnerabilities of even powerful economies. But the wrong lessons were taken, and many were unprepared for the 1997 Asian Financial Crisis and the global crisis of 2007-2008.
In the late 1980s, Japan experienced an economic bubble where stock and land prices tripled, even though underlying economic data did not justify such rapid growth. This was known as Japan’s “bubble economy.”
The bubble was financed mainly by bank loans from traditionally conservative Japanese banks. As banks offered riskier loans with higher interest rates, it created a moral hazard problem where borrowers had incentive to take on risk since someone else (the banks) would bear the cost of failure.
Similar bubbles fueled by looser bank lending occurred elsewhere in the 1980s, like the US savings and loan crisis. Economists argue this pattern of bank lending creating moral hazard is a common cause of economic bubbles throughout history.
While Japan was known for long-term strategic thinking, the scale of its 1980s bubble was still surprising given this reputation. Speculative bubbles are inherently difficult to resist, even for prudent investors, when fueled by momentum.

So in summary, the passage explains how Japan’s 1980s bubble was sparked by a moral hazard issue arising from banks extending riskier loans, and compares this phenomenon to other economic bubbles historically.

The passage discusses moral hazard in lending and borrowing. It argues that normally lenders require borrowers to put up substantial collateral and restrict how borrowed money can be used to limit risk.
However, government guarantees on bank deposits create moral hazard by making depositors and bankers careless about risk. Unscrupulous bankers can take deposits and lend recklessly to profit themselves, knowing the government will bail out depositors.
Financial deregulation in the 1980s exacerbated this issue by giving banks more freedom and reducing penalties for risk-taking. This global epidemic of moral hazard contributed to Japan’s speculative bubble economy of the 1980s.
When Japan’s bubble burst in the early 1990s, the economy experienced a “stealthy depression” of slow growth rather than a clear downturn. Authorities failed to recognize the problem and stimulate growth adequately through monetary policy like cutting interest rates.
As a result, Japan became trapped in a decade of sluggish “growth recession” that left potential economic capacity unused and verged on a persistent “growth depression.” The passage argues this outcome was not inevitable given proper policy responses.
Japan’s economy slowed significantly after the bursting of an asset price bubble in the early 1990s. Despite cutting interest rates to nearly zero, the economy did not recover and fell into a prolonged slump.
One standard response to recession is deficit spending by the government to boost demand. Japan tried large stimulus packages in the 1990s, but they did not have enough impact and debt levels continued rising. Fiscal concerns grew about Japan’s ability to fund rising costs of an aging population.
Another response is to strengthen banks and boost credit to support spending. Japan enacted a large bank bailout in 1998, but the economy did not fully recover.
Getting some inflation could also help recovery by encouraging more spending before prices rise further. But economists were unprepared for Japan’s situation, known as a “liquidity trap,” where conventional monetary and fiscal stimulus do not work as expected. Japan remained stuck in a slump despite various efforts to restart growth.

In summary, the passage discusses how Japan fell into a prolonged economic slump after its asset bubble burst, and examines different policy responses like stimulus spending, bank bailouts, and inflation targeting, which did not fully solve Japan’s economic problems as theory would predict. Economists were surprised by Japan’s situation of remaining stuck in a “liquidity trap” recession.

This passage summarizes the economic boom and subsequent crisis in Thailand and wider Asia in the late 1990s. Some key points:

Thailand experienced rapid economic growth and industrialization starting in the 1980s, growing at over 8% annually. However, in the early 1990s its growth became increasingly reliant on foreign capital inflows.
Global factors like low interest rates and the emergence of “emerging markets” as an investment concept drove a huge surge in private capital flows to developing countries, including Thailand. These funds were channeled through various financial entities.
Maintaining a fixed exchange rate amid rising demand for its currency, Thailand’s central bank had to continuously increase the supply of baht, accumulating foreign exchange reserves. This left the country vulnerable to a crisis of confidence.
In 1997, Thailand devalued the baht, triggering a wider financial crisis across Asia as other currencies also came under pressure. The passage sets up why this contagion occurred despite Thailand’s small size in the global economy.

So in summary, it describes Thailand’s boom, growing dependence on foreign capital, and the currency crisis that began there but then spread much more widely, challenging prevailing models of economic development and growth.

Initially, loans from abroad in foreign currencies like yen expanded Thailand’s money supply and credit through the banking system. This fueled massive lending and investment, fueling a boom.
However, much of the lending and investment was speculative in real estate and stocks, resembling Japan’s bubble economy. Central banks tried to “sterilize” inflows but failed due to rising interest rates attracting more foreign loans.
By 1996-1997, some investments began failing as markets cooled. Foreign lending declined due to lost confidence, further slowing the bubble economy. Land and stock prices fell.
A key issue was “moral hazard” - politically connected Thai finance companies and individuals could borrow cheaply abroad with implicit government guarantees, fueling risky speculative investments. This propped up the bubble.
As foreign loans stopped increasing, the Bank of Thailand had to use reserves to support the baht’s value, but could only do so temporarily before the July 1997 crisis hit in full force.
The Thai government could print as much of its currency, the baht, as it wanted. However, it could not print dollars, which were being used to invest in Thailand.
To maintain the value of the baht, Thailand’s central bank had to use its foreign reserves to buy baht in currency markets. But its reserves were finite and would eventually run out.
Thailand hesitated to either raise interest rates and slow the economy to reduce baht in circulation, or let the baht’s value decline through devaluation. It hoped the situation would improve on its own.
Speculators saw Thailand was unwilling to take tough measures and began borrowing baht and converting to dollars, exacerbating the pressure on Thailand’s reserves.
Eventually Thailand had to either strongly defend the baht or let it float freely. But it continued to hesitate as reserves drained, until July 1997 when it let the baht’s value decline sharply against the dollar.
Contrary to expectations, Thailand’s devaluation triggered a wider economic crisis across Asia. As the baht fell, confidence declined and sparked a vicious cycle of falling financial markets, economic recession, and further loss of confidence. This feedback loop was more powerful than anticipated.
In late 1997, economists and officials met in Woodstock, VT to discuss the emerging Asian financial crisis. At the time, Thailand was clearly in trouble and Malaysia/Indonesia had seen currency depreciation of around 30%.
They saw Thailand’s problems as self-inflicted but thought Indonesia’s currency weakness was unjustified given its sound fundamentals like smaller deficits than neighbors. However, within 3 months Indonesia was in even worse shape and the crisis had spread to distant Korea.
Contagion occurred not just through direct economic/financial links but also because investors lumped Asian economies together in their minds as sharing a “miracle”. Troubles in one economy shook faith in all others and susceptible to self-fulfilling panic.
There were some triggering events like changes in yen/dollar rates affecting competitiveness, but Asia had weathered bigger shocks before. The key question is what made them vulnerable to a crisis now when flaws had existed for decades without trouble.
Neither Western conspiracy theories nor morality tales about cronyism fully explain the timing and breadth of the crisis across very different Asian economies. Vulnerability seems to have built up over years through overreliance on short-term foreign capital.
The passage discusses how financial crises are not merely punishments for sins or bad policies, but often due to economies becoming vulnerable to self-fulfilling panics. Even well-run economies can collapse when widespread fear and loss of confidence takes hold.
It analyzes the financial crises in Asia in 1997 and Argentina in 2002. Both economies had opened up their financial markets and taken on substantial foreign debts that amplified the impact of losing confidence/panicking creditors. Past policies were not the sole or main cause.
It argues economies had become more vulnerable over time due not to “crony capitalism” but because they engaged more with global capital markets and took on dollar-denominated debt, making them vulnerable to currency fluctuations. Losing confidence led to financial collapse through vicious feedback loops.
In both cases, mainstream economic policies aimed at restoring order (fiscal austerity, higher rates) backfired and deepened the crises, contradicting what worked in past crises in developed nations like cutting rates and stimulus. This policy “perversity” is the real issue worth debating.
In past decades, many emerging market economies followed Keynesian economic policies like controlling money supply and adjusting interest rates to stimulate or slow growth. However, when financial crises hit in the late 1990s, the IMF and U.S. Treasury pushed these countries to adopt austerity measures.
This seems paradoxical given how knowledgeable the IMF/Treasury economists were. The short answer is they were afraid of currency speculators attacking countries.
To explain this fully, we must understand the history and challenges of international monetary systems. Originally there was a global currency (the “globo”) managed by a global central bank, but economies’ needs diverged.
When separate currencies emerged, exchange rate volatility increased as speculation dominated currency markets. Countries tried stabilizing rates but were still vulnerable to speculative attacks that forced policies not aimed at economic fundamentals.
Effectively, countries must choose between open capital markets, exchange rate stability, and autonomous monetary policy - they can only achieve two of the three. Fear of speculative attacks influenced the IMF/Treasury to prioritize open markets over counter-cyclical Keynesian policies.

Freely floating exchange rates are preferable to fixed rates or managed floats according to most economists by the mid-1990s. While exchange rates can be volatile, floating rates allow countries more freedom of monetary and fiscal policy. However, some countries are vulnerable to speculative attacks and self-fulfilling crises of confidence that undermine their currencies and economies. To regain confidence and avoid devaluations during crises in the 1990s, countries like Brazil were pressured to implement extreme austerity policies like high interest rates, tax increases, and spending cuts - directly contradicting traditional Keynesian responses of stimulus. These policies aimed to attract speculative capital inflows rather than support economic growth, demonstrating how market psychology and perceptions had undermined the previous Keynesian consensus on exchange rates and monetary policy.

The IMF demanded that crisis-hit Asian countries practice strict fiscal austerity through tax increases and spending cuts. However, this likely exacerbated recessions by reducing demand. Meeting austerity targets also undermined the sense of control, feeding panics.
The IMF also demanded extensive “structural reforms” beyond just monetary and fiscal policies. Some reforms addressed banking issues, but others like ending Indonesian business monopolies seemed unrelated to the crisis. This fueled suspicions of IMF imposing its ideology and prolonged negotiations, worsening the crisis of confidence.
The IMF told countries to raise interest rates very high to attract investors, but this likely fed the financial panic and recession. Simply letting currencies decline, as Australia did, may have led to more manageable devaluations and a better economic outcome with less rate hikes.
Overall, there were no good policy choices available under the international financial system rules. Various options - defending currencies, devaluing sharply, high rates - all had major downsides. While no one policy was clearly to blame, hedge funds prominently exacerbated panics through their actions in driving down emerging market currencies.
Hedge funds take highly leveraged positions in financial markets, allowing them to make outsized gains but also face potential losses beyond their capital. Their positions can significantly impact markets.
George Soros’s Quantum Fund gained fame and over $1 billion in 1992 by shorting the British pound, helping trigger its exit from the European exchange rate mechanism. While Britain’s membership was likely doomed anyway, Soros’ actions sped up the timetable. The devaluation ultimately helped Britain’s economy.
In 1997, Malaysia was hugely successful economically under Prime Minister Mahathir Mohamad. However, the Asian Financial Crisis devastated Malaysia. Mahathir railed against foreign speculators like Soros for betting against Asian currencies, though economists say domestic flaws were a larger factor in the crisis.
Events showed how highly leveraged hedge fund bets could influence markets and economies for better or worse, fueling debates around regulating these influential but lightly supervised investment vehicles. Soros established himself as arguably the most famous currency speculator.

Mahathir Mohamad, the prime minister of Malaysia, faced a currency crisis as money started flowing out of his country during the Asian Financial Crisis of the late 1990s. He blamed the financier George Soros for speculating against Asian currencies and causing economic problems. However, it turned out Soros’ fund Quantum was not actually responsible for outflows from Malaysia - many Malaysian businessmen themselves were moving money out of the country.

Nonetheless, Mahathir continued publicly attacking Soros, which further undermined confidence in the Malaysian economy. His accusations of conspiracies were seen as silly by most of the world.

Meanwhile, Hong Kong also suffered in the crisis as its economy declined along with its Asian neighbors. Some Hong Kong businessmen and hedge funds speculated that the currency peg to the US dollar could break, causing problems. Certain hedge funds, including possibly Soros’ Quantum fund, short sold Hong Kong stocks and currency, essentially betting that the Hong Kong Monetary Authority would either raise rates, hurting stocks, or devalue the currency.

The hedge funds’ actions looked like they could succeed in moving the markets. However, unexpectedly the HKMA fought back by using its large dollar reserves to buy Hong Kong stocks, driving prices up against the hedge funds’ short positions and preventing them from profiting on their bets. This unconventional action was criticized by some as market manipulation, though it succeeded in defending Hong Kong’s currency peg.

In the late 1990s, Russia’s economy was struggling to transition from socialism to capitalism. It faced many problems like unproductive factories and farms.
However, Russia still had a large nuclear arsenal, which the US was anxious about. So the US encouraged lending to Russia by the IMF to buy time for reforms.
This environment encouraged hedge funds to invest in high-risk Russian debts, expecting more Western bailouts if needed.
In 1998, Russia defaulted on its debts, causing huge losses for hedge funds that were heavily invested there.
This triggered a financial crisis as hedge funds had to unwind complex positions globally to cover losses. Asset prices plunged and liquidity dried up as they all sold assets.
It emerged that competition between hedge funds to exploit small opportunities had created a fragile system. Defaults in one market caused massive deleveraging across markets.
The Federal Reserve stepped in to rescue the famous but now troubled hedge fund Long Term Capital Management, to prevent broader economic damage. But it was a major financial panic.
Long Term Capital Management (LTCM) was a highly successful hedge fund that used computer models to make leveraged bets on asset price correlations. They delivered steady returns for years.
In the late 1990s, markets became volatile in ways the models didn’t anticipate. LTCM suffered massive losses and faced margin calls it couldn’t meet.
There were fears LTCM’s failure could destabilize markets further. The New York Fed organized a private sector bailout to inject capital into LTCM.
Separately, the US was facing a broader financial crisis in 1998. When the Fed only modestly cut rates, fears of a recession grew.
Greenspan was granted discretion for further rate cuts. His surprise additional 0.25% cut in October reassured markets and helped avert panic. However, some worried the Fed was seen as able to bail out any crisis.
The limits of the Fed’s power were exposed during the 2008 global financial crisis, showing risks of moral hazard from perceptions of a Fed “put.”
Alan Greenspan’s time as Fed chair during the Clinton years saw spectacular job creation and unemployment falling below 4%, but Greenspan allowed this to happen rather than raising rates preemptively.
Greenspan speculated low unemployment may not necessarily lead to inflation if productivity had changed the relationship, and waited for evidence of actual inflation before raising rates. Unemployment fell without inflation rising.
However, Greenspan was less successful when it came to bubbles in asset markets like stocks in the 1990s and housing in the 2000s. Both saw prices rise far above historical norms.
The stock bubble reflected tech optimism and belief recessions were over. Housing bubble had less justification but was driven by lax lending standards that allowed buyers to take on unaffordable mortgages on the assumption home prices would always rise.
While Greenspan’s permissive approach to low unemployment aided job growth, his failure to act on the developing asset bubbles had negative consequences that became clearer after he left office.
Mortgage lenders and brokers securitized home loans by assembling large pools of mortgages and selling shares in the payments received from borrowers to investors.
Previously, securitization was limited to high-quality “prime” mortgages, but the financial innovation of collateralized debt obligations (CDOs) made it possible to securitize riskier subprime mortgages.
CDOs offered shares of varying seniority - senior shares received first claim on payments and were rated AAA by credit agencies, making them attractive to institutional investors seeking safe investments.
This opened up large-scale financing of subprime lending. However, lenders and brokers did not properly evaluate loan quality because they sold the loans off rather than holding them. Investors also did not fully understand what they were buying.
As long as housing prices rose, the system operated smoothly. But when the housing bubble burst in 2006, defaults increased, exposing the risks that had built up in the convoluted mortgage-backed securities.
In the late 19th/early 20th century, “trusts” emerged as unregulated institutions that took deposits like banks but were not subject to the same reserve requirements as national banks.
Trusts were able to pay higher returns to depositors and grew rapidly, surpassing national banks in total assets in New York City by 1907.
However, trusts did not participate in the New York Clearinghouse, which guaranteed other members’ solvency, because that would require higher reserves.
The Panic of 1907 began when the large Knickerbocker Trust failed after speculation in stocks. Runs ensued on other trusts as depositors fled.
J.P. Morgan intervened to shore up bank reserves and stop the panic, but it exposed the vulnerabilities of the non-national banking system.
The 1913 Federal Reserve Act created a more regulated and centralized system, but the Great Depression showed more reforms were still needed to prevent future financial crises.
Glass-Steagall separated commercial and investment banking and insured commercial bank deposits, protecting the system for decades until the rise of shadow banking in the 2000s like auction-rate securities, outside of regulation.
The financial system had grown increasingly reliant on short-term funding in overnight repo markets ($2.5 trillion), hedge funds ($1.8 trillion), and the combined balance sheets of major investment banks ($4 trillion).
This “shadow banking system” was undertaking bank-like activities like lending and borrowing without the same regulations as traditional banks. It was highly vulnerable to runs without protections like deposit insurance.
The crisis exposed weaknesses in assets like auction-rate securities, asset-backed commercial paper, and the business models of investment banks. It also impacted entities like AIG and international carry trades.
Despite warnings like the near-collapse of Long Term Capital Management, there was a lack of oversight and a belief in “financial innovation.” The growing risks of the shadow banking system were ignored or dismissed. Politicians failed to regulate these new institutions undertaking bank-like functions.
The housing bubble began to deflate in 2005. By mid-2007, prices had fallen around 3% from peak. Declines accelerated, especially in hard-hit regions. This undermined the subprime lending model and caused default rates to rise as homeowners could no longer refinance or sell their way out of trouble.
Creditors typically only get back about half the original value of a loan when foreclosing on a house. However, loan restructuring costs money and requires staff resources.
Subprime loans were originated and then quickly sold off, so the originators did not hold on to the loans. Loan servicing was left to servicers who lacked incentives and resources for restructuring.
The complex securitization of subprime loans made debt forgiveness legally difficult due to dispersed ownership among investors.
This led to costly foreclosures instead of restructuring. Securities backed by subprime mortgages then became bad investments as the housing boom faltered.
Losses on lower-rated mortgage-backed security tranches in early 2007 ended subprime lending. This removed housing demand and worsened the slump.
Even senior AAA tranches eventually suffered losses as the scale of housing overvaluation became clear - requiring up to 50% price falls nationally and more in some areas.
This meant almost all homeowners in bubble areas faced negative equity, a key driver of default and foreclosure regardless of credit background.
Investor losses of around $1 trillion triggered collapse of the shadow banking system through deleveraging and loss of confidence, comparable to bank runs in the 1930s. This credit crunch worsened the crisis beyond the housing sector.

This passage summarizes the challenges facing the Federal Reserve under Bernanke during the current financial crisis. Some key points:

Bernanke is well-qualified intellectually to deal with the crisis due to his academic research on the Great Depression and Japan’s banking crisis of the 1990s.
However, the Fed has struggled to impact financial markets and the broader economy. Interest rates cuts have not translated to lower rates for risky borrowers like subprime mortgages.
The crisis affected sectors outside traditional banking like money market funds, hindering the Fed’s direct lending to banks.
The Fed faces a “liquidity trap” like Japan in the 1990s, where further rate cuts may have little effect.
It has tried new measures like lending facilities but with limited results so far, possibly due to the huge size of the credit markets.
The crisis has developed dimensions the Fed did not foresee, such as triggering a currency crisis in emerging markets through increased financial globalization and risky cross-border investments.

So in summary, while Bernanke is highly qualified, the Fed has found the crisis exceptionally challenging to manage due to its unconventional nature and global scale.

Major investment bank Lehman Brothers collapsed in September 2008, accelerating the global financial crisis. The government chose not to bail out Lehman like it did for other firms, undermining confidence.
This led to a plunge in asset prices and drying up of credit. The bailout of AIG failed to calm markets. Emerging markets were hit as the “carry trade” currency flows reversed.
The crisis spilled over from financial markets to the real economy. Housing busts led to recessions, but the financial collapse made things much worse, likely causing the worst global recession since the 1980s.
Policy tools like interest rate cuts lost effectiveness, reminiscent of Japan’s lost decades, causing a return of “depression economics.” Demand shortfalls rather than supply constraints now limit growth in many countries. The risks of prolonged downturns due to insufficient spending have returned after being absent for decades.
In the late 1990s and early 2000s, several countries like Indonesia, South Korea, and Argentina experienced economic recessions that undid years of progress. Conventional policy responses did not seem to work.
By 2008, the global economy was experiencing a full-blown crisis. The credit system froze up and a global economic downturn was building.
To deal with the crisis, policymakers needed to do two things: get credit flowing again and prop up spending levels. Recapitalizing financial institutions by providing more capital was identified as key to restarting lending. Temporary nationalization of banks might be needed if initial efforts were insufficient.
Beyond recapitalization, governments also needed fiscal stimulus through public works projects and infrastructure investment to boost aggregate demand. The stimulus plans in 2008 were too small and relied too much on tax cuts rather than spending.
Once the immediate crisis was addressed, longer-term financial reforms would be needed to prevent future crises. The root causes of the crisis related to failures in the regulation of banks and broader financial system.

So in summary, a two-pronged approach was needed for rescue - recapitalizing banks to get credit moving again plus fiscal stimulus to support aggregate demand, followed by financial reforms to fix the regulatory system.

In the 1930s, the financial system was placed under tight regulation and supported by a strong safety net. International capital flows, which contributed to the crisis, were also limited. This made the system safer but less dynamic.
In the 1990s and 2000s, growing global capital flows and the growth of the unregulated shadow banking system set the stage for major currency crises and the 2008 global financial crisis. These developments showed that financial globalization had become more dangerous than realized.
The lessons of the Great Depression need to be relearned - any institution that is systemically important and may require rescue should face regulation, as commercial banks have since the 1930s. Regulation also needs to be reconsidered in light of financial globalization and the challenges it presents.
Keynesian economics remains highly relevant for understanding economic slumps, as discussing obsolete economic doctrines can impede solutions. Ideas, not just interests, influence whether times of crisis lead to good or evil outcomes. Maintaining stimulus policies is important to avoid relapsing into further depression, as seen with the policy reversal in 1937.

The short-seller borrows an asset from another investor, sells it at the current market price, and hopes that the price will fall by the time they have to buy it back to return it. In the meantime, the short-seller has extra cash from selling the borrowed asset that can be invested elsewhere, taking a long position in another asset.

However, the lender of the borrowed asset wants assurance that the short-seller has enough wealth to buy the asset back at the agreed upon time. When short-sellers suffer heavy losses, they are no longer able to borrow large amounts of assets like before. If large short-sellers are significantly impacted, it can have broader consequences in the market.

#book-summary

Return of Depression Economics and the Crisis of 2008, The - Paul Krugman