Friday, March 7, 2008

Paul Krugman is scared.

It's official: Paul Krugman, who is widely considered the most celebrated economist of the present time, is scared. The entire financial system has never been closer to toppling since The Great Depression. Paul Krugman is asking "What should be done?" and cannot think of an answer. Why? Because there is no answer that doesn't involve lots and lots of economic pain. Consider the following chart (courtesy SGS):


It shows money supply growth rates. M3 is money including all the credit, M1 is basically just cash (i.e. bank accounts and the like).
The problem here is that total credit (M3) is expanding at almost 20%, and the cash supply (M1) is expanding at 2% at best. This was going on for many years. But you have to pay the interest on your credit (M3) from your cash(M1). You can buy a TV on credit card, but you pay credit card bill from your bank account (at least eventually). In other words, amount of interest you have to pay eats more and more of the cash available in the economy, up to the point where this cannot go on anymore (i.e. this whole thing breaks down when M3*InterestRate == M1). This is the classical failure of the fractional reserve banking.

What happened is lenders thought they were richer than they really were (because they thought all those loans they owned represented purchasing power; they didn't because there wasn't enough money in the economy to ever call those loans back and buy something).

Now the answer to the question "What can be done?" becomes obvious doesn't it? Lenders must acknowledge that they don't own as much as they thought. They can either work out deals with creditors by reducing principal etc (what Bernanke tried to suggest) or by forcing creditors to default (what actually happened in Great Depression and almost every other crisis). Since there is no mechanism in place for lenders to reduce principals and they would be opposed to working out such mechanism quickly enough, we probably cannot do anything at this point. just let the defaults cascade through the system and hope we can unravel them...

And in order to avoid this situation from occurring again and again, fractional reserve banking needs to be replaced by a sane system, where amount of credit would not be allowed to experience runaway unchecked growth. Here is what happened to our money supply over the years (courtesy Wikipedia):

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