Paul Krugman's Ideological Campaign for the Return of 'Depression Economics'


12-08-08, 9:19 am

Paul Krugman has launched a determined ideological campaign for the return of the ideas of John Maynard Keynes as the best and most effective framework, for both economic theory and policy, to address the rapidly spreading global financial and economic crisis. For public policy this campaign implies 'very significant' public investments in jobs, income, infrastructure, education. By significant is meant surpassing in size, per year, – if you want to return to something greater than zero growth – the expected contraction in the economy from Dec, 2007, the official start of the current Recession, until it ends. The forecasters with the most accurate record in this crisis expect a 4-6 percent contraction lasting 5-6 additional fiscal quarters. The number of economists predicting double-digit official unemployment rates is swelling. Nonetheless, one should be cautious interpreting any forecasted numbers...economic forecasting is no less difficult or uncertain than weather forecasting.

Krugman says we are in an era of 'depression economics' where the reigning economic economic ideology of monetarism fails, the ideas of John Maynard Keynes are vindicated, and a New, New Deal is on the agenda -- a 'Deal' now requiring government intervention orders of magnitude greater in size than ever contemplated or enacted by FDR: 'Has anyone else noticed that the current crisis sheds light on one of the great controversies of economic history? A central theme of Keynes's General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their magisterial monetary history of the United States, claimed that the Fed could have prevented the Great Depression — a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Fed caused the Depression.

Now, what the Fed really controlled was the monetary base — currency plus bank reserves The base actually rose during the great slump, which is why it's hard to make the case that the Fed caused the Depression. But arguably the Depression could have been prevented if the Fed had done more — if it had expanded the monetary base faster and done more to rescue banks in trouble.

So here we are, facing a new crisis reminiscent of the 1930s. And this time the Fed has been spectacularly aggressive about expanding the monetary base: And guess what — it doesn't seem to be working. I think the thesis of the Monetary History has just taken a hit.

If Keynes receded in our consciousness over the past few decades, it wasn't mainly because of uninformed criticisms from the right; it was because central bankers seemed to have everything under control. Uncle Alan and his counterparts, by controlling the money supply, could do the job of stabilizing the economy, and Keynesian fiscal policy seemed irrelevant.

Now, Keynes understood the role of monetary policy quite well, and believed that it had been effective in the past. What he argued, however, was that there were situations in which monetary policy could do no more – and that the world economy he lived in was facing such a situation: To be sure, Keynes failed to foresee the postwar rise of the 'marginal efficiency of capital' – the way that economic growth combined with inflation would create an environment in which interest rates were high enough in normal times that monetary policy was effective at fighting slumps. Hence the long era in which Keynes didn't seem all that relevant. But his analysis remained as valid as ever, under the right conditions. Those conditions reappeared first in Japan during the 90s; now they're everywhere.

And in the long run, it turns out, Keynes is anything but dead.'
Recently armed with the Nobel Prize in Economics for his work in international trade and economies of scale, and widely read as an op-ed columnist for the New York Times, Krugman is accelerating his assault on the commanding heights of the economic orthodoxy of recent decades – supply-side, trickle-down, you-only-need-to-rely-on-Alan-Greenspan economics. Once the liberal pariah among commentators, the recipient of hundreds of death threats for his fearless ridicule of Bush's economics and Iraq war policy even at the height of the President's popularity: he is not alone anymore, having gathered an large and growing league of supporters and collaborators within and without his profession along the way.

Brad Delong, an economist at the University of California,and a former Deputy Secretary of the Treasury in the Clinton Administration, reviewing Krugman's book 'The Return of Depression Economics and the Crisis of 2008' – reflects the emerging consensus much closer to Krugman's theoretical position. 'A decade ago, Paul Krugman wrote a little book warning us that economists' triumphalism was misplaced -- that advances in economic knowledge and economic policy had not, after all, banished the prospect of big depressions from the global economy. 'The Return of Depression Economics' sank with barely a ripple. After all, the East Asian financial crisis of 1997-98 – although sharp – was short and quickly cured once the International Monetary Fund realized that the crisis was not the fault of governments and once Senate Republicans allowed the U.S. Treasury to intervene in world markets. Japan's economic problems during its lost-growth decade of the 1990s were, economists asserted, peculiar to itself. And the collapse of the dot-com bubble in 2000-01 brought on not a depression but merely an output decline so mild as to barely warrant the name 'recession.'

'Now Krugman is back, with a Nobel Prize and a crisis that is orders of magnitude worse than the East Asian one. And he is back with more than a second edition in 'The Return of Depression Economics and the Crisis of 2008.' He returns with a stronger argument, as the current financial crisis serves as a third example, alongside Japan's lost-growth decade and the East Asian crisis, of 'depression economics.''
What about the opposing tendencies? Greg Mankiw [former Bush chairman of the council of economic advisers] gives a more orthodox ('monetarist') argument, and it is already being reflected in the economic argumentation behind Republican objections to the very large fiscal stimulus and energetic regulatory reforms that Krugman, fellow Nobel Prize winner Joseph Stiglitz, and their supporters propose as necessary for economic recovery. But, as you will notice in the emphasized sentence below, the force of the 'Return of Keynes' assault is having an impact even here: 'Should we worry about government debt and future generations when devising fiscal policies to rescue the economy from it short-run troubles? In particular, should these concerns lead us to a smaller fiscal expansion than we might otherwise pursue? Some economists, such as Dean Baker and Paul Krugman, argue the answer is no. Worries about the budget deficit, in their view, should not deter fiscal expansion. In essence, they say that future generations would be even worse off if we live through a period of depressed aggregate demand, high unemployment, and consequently reduced investment.

'...In my view, these arguments are cogent only under the maintained assumption that there is no good alternative to fiscal expansion....but I continue to believe that there are other choices. Typically, these put monetary policy front and center...... one thing all economists agree on: If there are public investment projects that pay a high rate of return, those are worth paying for, even if it means more borrowing. But that is always true. Even if we were at full employment and there were no possible employment effects of fiscal stimulus, we should undertake public investments that pass a cost-benefit test.'

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