The return of Depression Economics

By Professor Paul Krugman Professor of economics and international affairs at Princeton University and the recipient of the 2008 Nobel Prize in Economics

• Introduction
• Rescue help unclear
• Earlier jump start
• Financial reform
• Lessons to be drawn

 Introduction

The world economy is not in depression. But while depression itself has not returned, depression economics – the kind of problems that characterised much of the world economy in the 1930s but have not been seen since – has staged a stunning comeback.

Fifteen years ago hardly anybody thought that modern nations would be forced to endure bone-crushing recessions for fear of currency speculators, and that major advanced nations would find themselves persistently unable to generate enough spending to keep their workers and factories employed. The world economy has turned out to be a much more dangerous place than we imagined.

What does it mean to say that depression economics has returned? Essentially it means that for the first time in two generations, failures on the demand side of the economy - insufficient private spending to make use of the available productive capacity - have become the clear and present limitation on prosperity for a large part of the world.

Even now, many economists still think of recessions as a minor issue, their study as a faintly disreputable subject. Robert Lucas, a Nobel Prize winning economist, explicitly made the case that the business cycle was no longer an important subject, and that economists should shift their attention to technological progress and long-run growth. These are fine, important issues, and in the long run they are what really matter – but as Keynes pointed out, in the long run we are all dead.

 Rescue help unclear

An extensive financial rescue is now underway in the UK, the US and most of the developed nations, although in the US it was late in coming, thanks in part to the ideological tilt of the
Bush administration.

My guess is that recapitalisation will eventually have to get bigger and broader, and that there will eventually have to be more assertion of government control – in effect, it will come closer to a full temporary nationalisation of a significant part of the financial system. Just to be clear, this isn’t a long-term goal, a matter of seizing the economy’s commanding heights: finance should be re-privatised as soon as it’s safe to do so. But for now the important thing is to loosen up credit by any means at hand, without getting tied up in ideological knots. Nothing could be worse than failing to do what’s necessary out of fear that acting to save the financial system is somehow “socialist”.

The spread of the financial crisis to emerging markets makes a global rescue for developing countries part of the solution to the crisis. As with recapitalisation, parts of this were already in place at the time of writing: the International Monetary Fund was providing loans to countries with troubled economies like Ukraine, with less of the moralising and demands for austerity that it engaged in during the Asian crisis of the 1990s.

 Earlier jump starts

Now, the US tried a fiscal stimulus in early 2008; both the
Bush administration and congressional Democrats touted it as a plan to “jump-start” the economy. The actual results were, however, disappointing, for two reasons. First, the stimulus was too small, accounting for only about 1 per cent of GDP. The next one should be much bigger, say, as much as 4 percent of GDP. Second, most of the money in the first package took the form of tax rebates, many of which were saved rather than spent. The next plan should focus on sustaining and expanding government spending – sustaining it by providing aid to state and local government, expanding it with spending on roads, bridges, and other forms of infrastructure.

The usual objection to public spending as a form of economic stimulus is that it takes too long to get going – that by the time the boost to demand arrives, the slump is over. That doesn’t seem to be a major worry now, however it’s very hard to see any quick economic recovery, unless some unexpected new bubble arises to replace the housing bubble. (A headline in the satirical newspaper The Onion captured the problem perfectly: “Recession-Plagued Nation Demands New Bubble to Invest In.”) As long as public spending is pushed along with reasonable speed, it should arrive in plenty of time to help – and it has two great advantages over tax breaks. On one side, the money would actually be spent; on the other, something of value (e.g., bridges that don’t fall down) would be created.

Some readers may object that providing a fiscal stimulus through public works spending is what Japan did in the 1990s – and it is. Even in Japan, however, public spending probably prevented a weak economy from plunging into an actual depression. There are moreover, reasons to believe that stimulus through public spending would work better in the UK and the US, if done promptly, than it did in Japan. For one thing, we aren’t yet stuck in the trap of deflationary expectations that Japan fell into after years of insufficiently forceful policies. And Japan waited far too long to recapitalise its banking system a mistake we hopefully won’t repeat.

And once the recovery effort is well underway, it will be time to turn to prophylactic measures: reforming the system so that the crisis doesn’t happen again.

 Financial Reform

We have magneto trouble, said John Maynard Keynes at the start of the Great Depression: most of the economic engine was in good shape, but a crucial component, the financial system, wasn’t working. He also said this: “We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.” Both statements are as true now as they were then.

How did this second great colossal muddle arise? In the after-math of the Great Depression we redesigned the machines so that we did understand it, well enough at any rate to avoid big disasters. Banks, the piece of the system that malfunctioned so badly in the 1930s, were placed under tight regulation and supported by a strong safety net. Meanwhile, international movements of capital, which played a disruptive role in the 1930s, were also limited. The financial system became a little boring but much safer.

Then things got interesting and dangerous again. Growing international capital flows set the stage for devastating currency crises in the 1990s and for a globalised financial crisis in 2008. The growth of the shadow banking system, without any corresponding extension of regulation, set the stage for latter-day bank runs on a massive scale. These runs involved frantic mouse click rather than frantic mobs outside locked bank doors, but they were no less devastating.

 Lessons to be drawn

What we’re going to have to do, clearly, is relearn the lessons our grandfathers were taught by the Great Depression. I won’t try to lay out the details of a new regulatory regime, but the basic principle should be clear: anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated when there isn’t a crisis so that it doesn’t take excessive risks.

Since the 1930s, in the US, commercial banks have been required to have adequate capital, hold reserves of liquid assets that can be quickly converted into cash, and limit the types of investments they make, all in return for federal guarantees when things go wrong. Now that we’ve seen a wide range of non-bank institutions create what amounts to a banking crisis, comparable regulation has to be extended to a much larger part of the system.

We will not achieve understanding we need, however, unless we are willing to think clearly about our problems and to follow those thoughts wherever they lead. Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.

Extracted from The Return of Depression Economics and the Crisis of 2008 available at £9.99 from penguin.co.uk.

Copyright © Paul Krugman 2009, 1999 by Paul Krugman
Used with the permission of the publishers, W. W. Norton & Company, Inc and Penguin UK.

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