Sunday, December 7, 2008

What is Depression Economics?

Brad DeLong reviewing the revised version of Paul Krugman's book, The Return of Depression Economics and the crisis of 2008, defines "depression" thus

Cast yourself back 500 years ago to the docks where Antonio, the merchant of Venice, is loading the goods for a venture onto one of his ships: the spices of the Indies, the silks of Cathay and the intoxicants of Araby. But in order to carry out his venture, he needs investors: Shylock, say. Suppose that the morning comes to set sail and Shylock balks -- says that he needs his money now to pay for the wedding of his daughter or that the venture is too risky and he wants to keep his wealth close at hand.

Suppose also that Shylock's change of mind is a general change of mind -- that no replacement financier can be found. What happens? With a sigh, Antonio unloads his ship and carries his spices, silks and intoxicants off to the local market, sells them and then returns his money to Shylock. No big problem.

Now flash-forward to today. The capital stock of our economy no longer consists of valued consumption goods -- spices, silks, intoxicants -- for which there is a ready consumer market. The capital stock of our economy instead consists of the semiconductor fabrication facilities of Applied Materials, the patents of Merck, the roadbed of CSX -- not at all the kind of things that command money on short notice in the consumer marketplace.

Now what happens when everybody -- or a small but coordinated subset of everybodies -- decides that they want liquidity (their money now rather than in the five to 10 years it will take enterprises to pay dividends) or safety (the world is risky enough, thank you, and they don't care about the upside as long as they are protected on the downside)?

In normal times, when one investor wants more liquidity or safety, another will be willing to take on duration and risk, and they will simply swap portfolios at current market prices. But in abnormal times, they cannot: The semiconductor fabs are long-run, durable, risky assets that cannot practically be liquidated. And so when the everybodies all decide that they want liquidity and safety -- well, the economy cannot magically liquidate the fixed capital stock at a reasonable price. And to liquidate at falling prices creates mass unemployment. This is the key to "depression economics." And this is why the industrial business cycle emerged as a disease of the Industrial Revolution.

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