Paul Krugman: The International Finance Multiplier

[Kurt_and_Hunter]

The International Finance Multiplier

Paul Krugman October 2008

1. Introduction

The current financial crisis is remarkable in many ways, but one aspect is of special interest for international economists: even though the roots of the crisis lie in the U.S. housing market, the crisis is now very much a global affair. Figure 1 shows the decline in a number of stock market induces over the year ending October 4, 2008; essentially, all markets fell by the same amount. 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 Euro and the Rep rate similar to that between Labor and the Fed funds rate. Banks are failing, or needing urgent government rescue, on both sides of the Atlantic...

PD FORMAT

http://www.princeton.edu/~pkrugman/finmult.pdf

[On the Road]

1. The Equations are a Bit Much to Tackle

But this statement struck me:

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 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.

It seems to me that Paulsen's plan of buying up mortgages would address the capital situation. In addition to trading cash for mortgages, the feds could also simply buy stock -- is that what Krugman is suggesting?

[Kurt_and_Hunter]

2. I know he's a fan of capitalization through purchase of preferred shares

So I think you are reading that correctly. (Sort of what the UK did today.)

One reason I supported the bail-out despite the "it cannot work" angle is that I never thought the money would be used only for the purpose described. It's really just a rapid-reaction fund for Treasury as an adjunct to the powers of the Fed, FDIC etc..

Including capital investment, which folks are already talking about doing with bail-out funds.