Paul Krugman has a very good, if scary column for Monday's New York Times. Here's the money quote:
The current U.S. financial crisis bears a strong resemblance to the crisis that hit Japan at the end of the 1980s, and led to a decade-long slump that worried many American economists, including both Mr. Bernanke and yours truly. We wondered whether the same thing could take place here — and economists at the Fed devised strategies that were supposed to prevent that from happening. Above all, the response to a Japan-type financial crisis was supposed to involve a very aggressive combination of interest-rate cuts and fiscal stimulus, designed to prevent the crisis from spilling over into a major slump in the real economy.
Why does Krugman think we're "turning Japanese"? More on the flip.
The key problem here is the key concept in finance called "leverage". Modigliani and Miller got a Nobel Prize for a key insight in the economics of finance: it shouldn't matter in an "efficient market" how a company gets financed, as long as the effects of taxes, bankruptcy risk, and players have enough relevant information to know what's going on. A company should be able to finance itself from some combination of equity (e.g. stocks, withheld profits, and assets) and debt, according to what's convenient. The ratio of debt to equity in this equation is what we mean by "leverage".
Leverage can be a very good thing if you're starting up a business, since it means you can raise less capital to get started, and borrow enough to do what you need to get done. It is also dangerous.
This takes a little simple arithmetic. I'll use the simplest case, which if you understand it, you'll know enough to see what's scaring Krugman. Here's an excerpt from the Wikipedia article:
This is not too hard to understand, even if you're a bit math phobic, so stay with me. The main piece we are really interested here is the D / E part of the equation, the debt to equity ratio. The firm's return on equity, the "k-e" part, goes up when up is higher when D / E is higher. In practice, this means that the company's stock (which is just a portion of the company's equity) is goes up faster when things go up (good) and down faster when things go down (not so good).
This has something to do with why the market got so bad so fast for investors during the great crash of 1929. Many, many people bought stock "on margin" -- they borrowed money to buy stocks. They were personally leveraged.
When everything was working out well, that meant you could put up $10 of your own money, borrow $90, and buy $100 of stock. When the stock went up to $200, you could sell the stock, pay off the $90, and end up with $110 -- your original $10, and a tidy $100 in profit. Nice deal.
But suppose that instead of going up to $200, the stock fell to $20. Now you owe your lenders $90, but you only have $20 in stock to back it up. Lenders don't like this. Assuming the people you borrowed the money from weren't the kind that like to break your legs, then typically something called a "margin call" occurred -- you had to come up with some additional money to cover some part of that $70 you owed that wasn't covered by the stock. And on October 24, 1929 and following, an awful lot of people found that they had margin calls they could not cover. This was very bad for you, even if your lender did not intend to immediately break your legs.
After all this happened, the Federal government, under FDR's leadership, made changes in a variety of laws to prevent this sort of thing from happening again. These laws were not perfect, but people like "Foreclosure" Phil Gramm, one of McCain's top economic advisors over last few years, figured the country didn't really need these sorts of laws. And as a very powerful senator at the time, Phil could do something about this, and did. So we are in many ways very close to the situation we were in 1929 in many respects.
So we return to Krugman. He points out:
As the economist Irving Fisher observed way back in 1933, when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a "stampede to liquidate" is a severe economic slump.
That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money ... lately just about every financial institution has been trying to reduce its leverage — but the plunge in asset values has nonetheless left these institutions with more debt relative to their assets than before.
Short version: the crash has occurred, and the margin calls are coming in faster than some of the players can handle. This happened in Japan in the 1990s -- also largely due to a real estate bubble. And Krugman is severely worried that we are seeing this now.
John McCain is very close to the people like Phil Gramm who made all of this mess possible. Someone should ask McCain why he thinks these people are the best qualified to get us out of this mess.