This evening we attended a talk given by Paul Krugman at Seattle Town Hall sponsored by the Seattle World Affairs Council. Krugman is the 2008 winner of the Nobel Prize in Economics and a regular columnist at the New York Times.
Here’s a summary of his remarks.
Krugman started off by contrasting the current financial crisis with previous recessions as well as the Great Depression of the 1930’s.
The recession of the early 1980’s, until now the worst recession since the Great Depression, was largely caused by government policy. The oil price shocks of the 1970’s had left the US with an inflation rate of 13%. The Fed stepped in and raised interest rates in order to choke off inflation, which it did, causing a severe recession. Unemployment peaked at over 10%, the auto industry went into a tail spin because no one was buying cars. By mid-1982, inflation had eased and the Fed lowered interest rates. The economy rebounded quickly, just in time for Ronald Reagan to proclaim “it’s morning again in America.” So this was a recession that policy makers created – perhaps with reason – and knew how to end.
In contrast, pre-War and pre-1900 recessions tended to be caused by what we now would call “irrational exuberance.” People invested too much, took on too much debt, and eventually had a “Wile E. Coyote moment” when they realized they had run off the edge of the economic cliff. Today’s crisis is more like these pre-War recessions.
With one big difference: traditional monetary policy isn’t working. When this crisis started, interest rates were already low, around 5%. Now they’re effectively at the “zero lower bound.” The Fed has pulled its big monetary policy lever as far as it will go, and it’s still not causing the economy to rebound.
We’re in the Liquidity Trap that we learned about in ECON 101; no one is spending money despite high liquidity in the financial system.
Krugman described a number of paradoxes that characterize this type of situation, paradoxes where doing what seems right for the individual or family actually does harm to the economy as a whole.
- Paradox of Thrift: When times are tough and job security is uncertain, people tend to save more. In good times, increased savings is good because it makes more money available for lending and investment. In bad times when everyone saves, it causes a further slowdown in economic activity by reducing demand.
- Paradox of Deleveraging: Everyone is trying to sell off assets at the same time causing further price erosion.
- Paradox of Competitiveness: Employees take voluntary pay cuts and reductions in benefits in order to keep their jobs and improve the competitiveness of their employers. However, if everyone does this, then there is no competitive advantage gained, and employees may end up worse off with lower pay but unchanged debt.
All of which leads to deflation. (Note: It’s interesting that however much economists and policy makers hate inflation, they hate deflation even more. Understandable, really. While deflation is rarer, its effect in reducing economic activity – everyone holds onto their money because they believe goods will be cheaper in future – are scarier.)
He cited a few other reasons why this crisis is so difficult:
- The global nature of the crisis. “Latvia is the new Argentina,” he quipped, noting that countries in unexpected parts of the world are being hard hit.
- How “out of control and poorly protected” our financial system was. About 60% of the financial system (Note: 60% of what, I’m not sure: assets? transaction volume? debt holdings? Regardless, it’s huge.) was represented by the “shadow banking system,” completely unregulated and opaque. He suggested that a more encompassing definition of “bank” would be “anything whose collapse would cause financial chaos.”
- The Fed’s aggressive actions are not working either. Krugman seemed relatively supportive of his former Princeton colleague Ben Bernanke, whom he described as having been “demoted from department chair to running the world.” He noted, as have others, that Bernanke had studied the Great Depression, the Japanese recession and the rolling Asian financial crises of the 1980’s. He joked that the list of the Fed’s non-traditional actions read like Bernanke’s CV. “OK, we’ve tried his 2003 paper, and his 2004 paper, now his 2005 paper …” None of them seem to be working.
What’s left? Fiscal policy. I guess we’re all Keynesians now. Krugman worries that the government’s $825-billion stimulus package is in fact too small, that it will help but it won’t fill the approximately $2.5-trillion hole in the economy. He notes that the Obama Administration has watered down the spending package with tax cuts to obtain Republican support, but not a single House Republican voted to support the bill. He thinks the risks of such a large stimulus are less than the near certainty of the devastating consequence of inaction.
The outlook? Krugman thinks the recession will last 2-3 years, possibly longer. If we’re lucky, he says, unemployment will peak at 9%. What this means in terms of human lives is that roughly ten million people will fall below the poverty line. Another five million people will lose their health care coverage.
He believes the severity of the recession, in terms of GDP fall-off, may actually be worse in some other countries than in the US, but that human suffering will be worse in the US because of our poor social safety net. In no other developed country, for example, are people faced with the loss of health care when they lose their jobs.
A few additional comments from Q&A:
- Krugman is not worried about China dumping US dollars. First it would hurt them. “It’s not clear who has leverage here,” his said, citing the old line that if you owe the bank a million dollars you have a problem, but if you owe the bank 100 million dollars the bank has a problem. Second, if they did dump the greenback, the resulting lower dollar would stimulate US export demand and might actually help our recovery.
- There’s no turning back on globalization, despite its flaws. His main point here is that the developing world needs access to world markets. Traditional development economics has had zero success. Countries that have succeeded in making the transition from developing to developed, such as South Korea, have done so through export-led growth. Reverting to more local economic self-sufficiency would be horribly unfair to the developing world.
- Investments in green technology, however worthwhile, are too long term to have much effect on pulling the US out of recession. Investments in health care on the other hand could be more immediately beneficial because our system is so inefficient.
I wouldn’t call Krugman a great orator, but explains his dismal science with clarity and humor.