Another of my good summertime reads was Paul Krugman’s updated work “The Return of Depression Economics“, subtitled “and the Crisis of 2008″.  Sombre stuff, you might think, but 2008 Nobel Laureate Krugman, a Professor at Princeton, successfully explains global financial problems in an easy-to-comprehend style.

After the Great Depression of the 1930s, the world’s economists and central bankers thought they had the financial system under control.  Yes, there would still be dramas, but they wouldn’t break the system because the system’s managers knew what interventions to make.  Yet, time and time again, well-meaning  interventions often had unintended consequences. For example, Krugman explains how currency boards (currently advocated in some quarters here in NZ) seem to solve one problem but create the seeds of other, far more damaging problems.  He also shows how regulatory and intervention mechanisms failed to keep up with the rapidly evolving nature of sophisticated financial mechanisms, the increased linkages within the system, and the hazardous distancing between risk and reward. The term “moral hazard” is explained by example, and occurs frequently. And Krugman argues that, contrary to popular opinion, the system is not as predictable and manageable as many people believe. Perhaps the biggest factor is the mood of the market (that’s you and me), which frequently defies logic and common sense, both on the way up and the way down.

Krugman finishes off with some broad-brush suggestions for financial system reform; in summary, anything “too big to fail” or likely to cause the system to fail should be regulated.  Beyond keeping main-street banking separate from investment banking, I’m sceptical.  If markets had been allowed to operate properly in the 1990s and 2000s, the system would probably have had some shocks but not as bad as those consequent to well-meaning interventions. Also, more regulation implies a degree of foresight and political/regulatory strong-mindedness noticeably absent in recent years.  Krugman also doesn’t address any alternatives, eg. whether anything too big to fail should be broken up.  However, I do agree  that risk and reward (eg. borrower and ultimate lender) need to be closely coupled.  The iterative repackaging of housing loans that enabled the sub-prime crisis broke that coupling.

My only other serious criticism of this very interesting book is that the updated version was written a year (or two) too early.  Originally published in 1999 in the aftermath of the Asian and Latin American financial crises, the new edition brings in the most recent cataclysm affecting the world financial system, and explains how multiple linked failures brought the world’s financial system close to collapse, but the $700 billion US TARP package was only just being implemented at the time of writing.  Krugman really needs to bring into account the events and interventions  of 2009 (such as the auto industry bailout), and the way the world system coped. No doubt a further edition will address this problem.

Despite that, it’s well worth the time to read it. The Economist described Krugman’s book as “essential reading”.  I agree.