Equations and everything!
Krugman's latest [PDF]. Equations make my eyes glaze over -- do we have any economists around who can translate? -- so I'll cherry-pick some paragraphs that caught my eye:
The freeze on interbank lending and in the commercial paper market is affecting Europe to much the same degree that it’s affecting the United States, with the gap between Euribor and the repo rate similar to that between Libor and the Fed funds rate. Banks are failing, or needing urgent government rescue, on both sides of the Atlantic.
Note, as usual, how the phrasing exhibits lack of agency: "the freeze... is affecting." But who's doing the freezing? I have yet to see anyone confront and refute Newberry's theory that the crisis is caused by greed, not fear. (After all, if you were in a posse of infestment bankers, and you could get the government to hand you a trillion dollars, no strings attached, just because you "freeze" interbank lending and cause other people a lot of pain, what would you do?*)
Imagine a world in which there is only one questionable asset (think mortgage-backed securities). This asset is in fixed supply A. There are two kinds of investors who might hold the asset: the general public, on one side, and highly leveraged institutions (HLIs) on the other.
The demand of the general public for the asset in question will simply be assumed to be downward sloping in the asset’s price....
The implied demand curve from HLIs is therefore upward-sloping, because of the valuation effects on their balance sheets. This is, of course, the key to the whole story.
Oh-kay... Can anyone explain what on earth an upward-sloping demand curve is? Sounds kinky, enough, but how it's key to the whole story eludes this finance noob. (And in stories, characters have motivations; see above, at "greed"). Is this the part where everything gets toxic?
Even in this case, however, balance sheet effects can have a major impact. Figure 6 shows the effect of a negative shock to asset demand – say, the horrifying realization by the general public that housing prices can, in fact, go down as well as up. This reduces the general public’s demand for risky assets, shifting the supply of these assets to the HLIs right and down. But this initial effect on the price is magnified through a multiplier effect, as falling asset prices force HLIs to contract their balance sheets, leading to further asset price declines, further contraction of balance sheets, and so on.
And so on, circling the bowl.
Yes: there has been a major increase in financial globalization in the sense that there are large international cross-holdings of assets.
First, it suggests that the core problem is capital, not liquidity – or at least that you can explain much of what’s going on without appealing to a breakdown of buying and selling per se. To the extent that this is true, rescue plans centered on making troubled assets liquid, like the [Bush + Reid + Pelosi + Obama + ] Paulson plan passed last week, won’t do the trick. Instead, what’s needed is an injection of capital, which can’t reverse the original shock, but can undo the financial multiplier effect of that shock.
So, can we spend the trillion on that, then? Or are the cash-hoarding bankers already fondling it in their vaults?
Second, the international implications: to the extent that we regard falling asset prices and their consequences as a bad thing, which we obviously do right now, this analysis suggests that there are large cross-border externalities in financial rescues. ... Capital injections by U.S. fiscal authorities would help alleviate the European financial crisis, capital injections by European fiscal authorities help alleviate the U.S. financial
crisis. Multilateral Man, come home – we need you!
Well, I'm sure the Bush administration will get right on that. Unless the Europeans start, well, laughing hysterically at the very thought. That could be a problem.
NOTE * I'll tell you. You'd do it, and then you'd do it again, because a trillion dollars isn't enough.