Krugman’s lost it today, with a bizarre column which would makes Michiko Kakutani on a bad day look sensible. Not only is it all predicated on a silly conceit (“if we’re going to have a crisis, here’s how”), but he can’t even get that much right. Here’s the weirdest bit:
There was still one big unknown: had large market players, hedge funds in particular, taken on so much leverage — borrowing to buy risky assets — that the falling prices of those assets would set off a chain reaction of defaults and bankruptcies? Now, as we survey the financial wreckage of a global recession, we know the answer.
Maybe I’m being idiotic here, but can someone explain to me how falling “assets” (that’s stock prices and bond prices) cause “defaults and bankruptcies”? It seems to me that Krugman’s missing at least one crucial link in the chain — a credit crunch — and that even a credit crunch wouldn’t necessarily lead to “the financial wreckage of a global recession”.
The fact is that profitable companies need to issue neither equity nor debt to keep on going, and that unprofitable companies are much more likely to be bought by profitable companies than they are to default or to declare bankruptcy. I’m not saying that a market plunge wouldn’t hurt hedge funds — although I’m not saying that it would, either. I’m just saying that it wouldn’t obviously and necessarily send the real economy into a disastrous tailspin.
(By the way, for fans of Krugman Predictions, here he is on January 29, 2002: “I predict that in the years ahead Enron, not Sept. 11, will come to be seen as the greater turning point in U.S. society.”)
Obviously real estate.
I haven’t read the article because I refuse to pay for Friedman, who is bundled with Krugman, but in that excerpt, “bankruptcies” appears to mean “bankruptcies of financial firms, particularly hedge funds”, and there’s a fairly obvious transmission mechanism there (margin calls) to explain why falling asset prices could lead to bankruptcies.
I dunno, it’s rare to refer to hedge-fund failures as “bankruptcies”. And in any case, why would hedge-fund bankruptcies cause a global recession?
I’m not an expert in these matters, just someone who has followed this issue closely.
Take look at most of the blogs listed in my “Econ Blogs – Second Shelf” on my blog to see more from those who have been, and continue to predict that indeed “hedge fund failures” could spell disaster.
Or you might look to some of the posts under my
PS. Mark Thoma has the Krugman article on his site.
Mark Thoma has every Krugman article on his site.
He leaves out a few words with … to avoid being legal charges from NYT. Krugman himself doesn’t seem to mind since he often sends Mark clarifying emails in response to comments.
i should read thoma’s except, but krugman’s concept made sense to me —
asset prices fall. those who borrowed to buy the asset (hedge funds) have to sell to close their position (or take profits elsewhere to boost liquidity/ meet margin). someone might not be able to exit in time, ergo goes bust.
hedge funds and others have added to the world’s appetite for risk assets. those who have an ongoing need for financing get into trouble. or at a macro level, it becomes harder for lots folks to borrow, the economy slows (i.e. a credit crunch) and that adds to economic weakness.
the issue as always is whether the financial system has sufficient buffers of capital and liquidity to absorb a shock and when a critical mass concludes that prices have fallen far enough and decides to come back into the market with some existing cash. krugman may not address that issue — felix, i know, thinks in general the financial system is well capitalized and risk is well dispersed so there isn’t much risk. but it does seem like a fair question to rise.
one question — are there any rumors of any big hedge funds that are in trouble after this week. macroman reports a lot of global macro funds had a lot of beta (i.e. market exposure) judging from how an index of macro funds seems to be doing … sort of curious. obviously, the size of the losses shouldn’t really wipe anyone out is everyone has the average loss, but the average may conceal a bit of dispersion. or maybe jsut about everyone had the same position (or a similar one) and did equally bad
I’ve got to catch up on all the “Stability Breeds Instability” and related market stuff this weekend since my day job precludes too much attenton during the week, but in response to Brad’s inquiry: Are big hedge funds in trouble?
I saw some stuff yesterday that indicated that the answer is no, as to “big hedge funds”. But also suggested that the more savvy players were shifting positions in advance, leaving the usual “pigs” to bear the brunt of the problems. If I find it today, I’ll leave a follow-up comment here.
It may well be several to many smaller funds that spell trouble, else it may be the big “banks” that have gathered up too much of the risk from too many places (or again a bunch of smaller banks), thinking (or acting like) they are hedged when there is no one with any real assets on the other side of the hedge.
Robert Reich hinted at last fall:
Of course it would turn out that the stuff I was remembering was by Citigroup, according to which hedge funds had moved out of credit risks in recent week, while traditional fund managers had moved in. She concludes that hedge funds are not going to be the biggest losers, but pension funds and commercial banks’ trading departments.
And of course I remembered it incorrectly. The trigger point for future problems may indeed not be hedge funds, but other soon-to-fail institutitons. Or maybe are really just tiresome and silly worrywarts.