Nobel Laureate Paul Krugman: Too Little Stimulus in Stimulus PlanPublished: February 19, 2009 in Knowledge@Wharton
Paul Krugman, who won the 2008 Nobel Prize in economics, and who is a columnist for The New York Times, said at the University of Pennsylvania yesterday that the stimulus package signed this week by President Obama falls far short of what's needed to jumpstart the economy.
This recession differs from most since the Great Depression in the 1930s, the Princeton economist, known for his left-of-center point of view, explained in a presentation to Penn students and faculty. Particularly since World War II, most recessions were to some degree self-imposed -- or at least their timing was elective -- as the Fed would cool down an over-heating economy by imposing higher interest rates. Eventually, with inflation more under control, the Fed would ease up.
This time is very different. Inflation is not the culprit, Krugman asserts. This is a "debt deflation" recession, he said, an old economic idea put forth by Irving Fisher in the 1930s that has drawn little interest over the years -- until now. In basic terms it means households have accumulated a lot of assets -- houses and stock primarily -- and also a lot of debt. "Housing and stock holdings have been savaged, but debt has remained fixed," Krugman said. "This is not your father's recession; it is your grandfather's ... or perhaps your great grandfather's. So, the problem is that the old solutions don't work."
The driver of the current recession is not a Fed-induced reaction to rising inflation. In fact, the problem is nearly the opposite. Today the real interest rates the U.S. government pays on key treasury instruments have been allowed to fall nearly to zero -- a zero interest rate policy (ZIRP, as some call it). The key implication of ZIRP: It renders monetary policy impotent, according to Krugman. That eliminates one of the government's chief levers of influence over the economy. "We did not appreciate how helpful persistent inflation could be."
At the same time, the former engines of growth in the private sector have gone silent, he noted, including housing, exports (which had been rising but are off 20% in recent periods), business investment and consumer spending. That has created a huge spending gap, which Krugman pegged at $2.9 trillion.
With monetary policy a non-starter, "That leaves nothing but government spending" to prime the pump, Krugman said. "That's pure Keynes."
So how does the stimulus package this week stack up as a Keynesian solution for what's needed?
"It's helpful, but it does not cover even one-third of the gap, so it's disappointing," Krugman said. Out of the $789 billion approved, only about $600 billion adds real stimulus, in Krugman's opinion. "So you've only got $600 billion to fill a $2.9 trillion hole." What's more, he argued that $350 billion of the package slated for tax cuts will provide some, but not much, stimulus traction because households are likely to save rather than spend large portions of it. That's the "paradox of thrift," Krugman noted. Normally, encouraging savings is a great plus for an economy. But in a downturn, households (and businesses) worry about the future more, and decide to conserve resources and spend less -- just when spending is needed most.
What's more, much of the proposed aid to state and local governments was stripped from the stimulus package during political negotiations needed to secure passage, Krugman noted. That was the most effective component because it would be spent quickly. State budgets are in serious trouble, and if the states knew more federal funds were on the way, they'd be more likely to decide immediately to defer layoffs and continue with construction and other projects requiring instant funding. Also, much of the planned infrastructure spending, while positive for the economy, will take up to two years to have its greatest effect.
Krugman said he supports the idea of temporarily nationalizing insolvent banks in order to help unfreeze credit markets and avoid government purchases of toxic assets at inflated prices that would bail out shareholders at the expense of taxpayers. Even "comrade Greenspan" has come around to this notion, Krugman said, a joke referring to former Fed chairman Alan Greenspan's surprise admission this week that he now believes some banks may have to be nationalized temporarily (read more on bank nationalization in this Knowledge@Wharton article).
So what will get us out of a protracted recession? Eventually, even with inadequate policy measures, there will likely be a spontaneous recovery. Goods "wear out, rust away," and people will someday want to buy new technologies that will be clearly superior to what they have now. "Look at auto sales," Krugman said. "At current buying rates it would take 23.9 years to replace the current stock." Obviously it's not going to take that long, he added. Buying rates will eventually pick up. How long could that take? No one knows for sure, but Krugman reached all the way back to the Panic of 1873 (kicked off by a bank bankruptcy) to note the kinds of down cycles economies can go through. Back then, the U.S. suffered a deep recession lasting five years, then bounced back with a three-year recovery, Krugman noted. Unfortunately, the recovery was followed by another five-year-long recession. "The question is: Could more effective policies have deferred that? I don't know." But he suggested that inadequate economic policies in the U.S. today could lead to something akin to the so-called "lost decade" of economic growth in Japan during the 1990s and early 2000s. In fact, noting that Japan's economy is falling precipitously today, Krugman said Japan could now be headed for "lost decades."
Overall, then, how much of a boost will be delivered by the stimulus? Its supporters say it will create 3.5 million jobs relative to what would happen if no action were taken, Krugman noted. "But there are 135 million workers in the U.S. and we're in one heck of a slump," he said, suggesting that the stimulus is falling short. And today's measures will only prevent the loss of 3.5 million existing jobs at best, not create new jobs, he added.
Given those views, it might be worth noting that Krugman prefaced his talk by pointing out that he has always been an "economic pessimist." Then again, he's hoping for a second round of stimulus down the road, under a budget process that may be able to get around the "political stalemate" and the ability of the minority Republican Party in Congress to obstruct or water down future initiatives by resorting to filibuster-based blocking tactics.