Holiday reading: The return of depression economics by Paul Krugman

Picked up a book from a local bookstore, The return of depression economy and the crisis of 2008 by the Nobel prize winner in economics: Paul Krugman. With his kind of caliber, he is definitely capable of writing stuffs that I cannot understand but he did a good job narrating past financial crisis in plain English.

I was looking for answers how we can prevent future financial crisis so that we all can feel secure investing our money. The bad news is no easy answer can be found because there is no perfect model available. Some how we have ten woks but only seven lids.

I am going to share just two ideas that left a deep impression in me: Latin American and Asian crisis.

Let's start with Latin American first. Argentina was abusing their printing press for years with inflation went through the roof, 3000% and poor economic growth. They even introduced a new currency the austral. The austral was used between 1985 to 1991 but it was a doomed currency, nothing seemed to work. They finally resorted to peg their currency to US dollar, every peso printed backed by every US $ in their reserve. The results were dramatic, inflation dropped to almost zero and capital began to flow and economy expanded.

However, solving one problem created another problem. The system has a problem to deal with contagion effect. During Mexico infamous Tequila crisis ( a currency crisis), international investor lumped all countries by region. They pulled out money from all countries spelled as Latin America. So, the contagion effects spread to Argentina though their fundamentals were Okay. What was worst the problem compounded by local investors/residents panic and lost faith in their own peso and begin to convert to USD that caused USD shortage. Luckily, American has Exchange Stabilization Fund came into rescue and injected US $ 12 billion to stop the panic.

This reminds me of some investors demanded US to pegged their dollar to gold to prevent abuses of their printing press. There is no doubt that this will create a lot more discipline in their fiscal or monetary policies but in event of financial crisis, when you cannot increase your money supply fast enough, the vicious cycle will bring to its to your knees -- begging for help but god is too far away. This was one of the problems faced during the Great Depression until FDR confiscated gold. I am not saying we should or we should not but this is what I meant no perfect model existed.

The other part of the story was Japanese carry trade. We all know that Japan has lost decades after the twin bubbles busted. Not only they have zombie banks, lowering interest rate to zero and building roads to no where still cannot cure themselves. What is worst, they exported the problem to others. When Japanese hungered for higher yield, they lent money to some Thai "finance" companies. So, these "finance" companies controlled by corrupt and cronies of government officers, borrowed in Yen that heated up the property speculation. So, everybody had a good time partying, making good and fast and easy money. They became increasing reliance on foreign borrowings. Thai Bath begin to strengthen but it has came to a point hurting its economy as export became uncompetitive. This created another problem, import imploded that created huge trade deficit. Well the government wanted to fix their currency instead of letting it rose making the problem worse. This has created a fertile ground for speculators to take advantage of shorting the currency. I think the rest is history, many of us went through that crisis ourselves.

We may be strong but sometimes earthquake originated somewhere sending Tsunamis to our shores creating sorrows and there is nothing we can do about it. So, I really think we are living in the age of high volatility. Nothing is safe anymore, it is not a question of if but when a crisis will return. Read this book, it will help you to understand more about risk and how tightly coupled are financial markets. Financial globalization is far more dangerous than I originally thought.