Our economy faces depression-like conditions, according to Paul Krugman, in its alarmingly high unemployment rate. It needn’t be that way, though, Krugman says – a few simple steps could quickly solve our problems.
His premise is correct; the devastating toll inflicted by high unemployment is a crisis of depressionary proportions. But Krugman’s diagnosis of the cause of unemployment is flawed and his solutions are misguided.
Krugman is the 2008 Nobel Prize-winner in economics and a professor at Princeton. His newly published book, End This Depression Now!, draws together previously published op-ed pieces in The New York Times and longer essays from its Sunday edition. You will find little new material here if you are a regular of his (and you should be – even if you vehemently disagree with him – because he is highly influential). But it is worth the read.
Krugman says in the preface that his goal was not to focus on the causes of the financial crisis, as others have done. Instead, it was to focus on solutions and answer the question, “What do we do now?”
But in the first 200 pages he does exactly the opposite, and rehashes what led to the crisis. You’ll read chapters about the pernicious effects of modern conservatism, how a belief in efficient markets was ruinous to the economy, why wealth inequality is destructive to society, and how a buildup of debt bred financial instability.
Only at the end of the book does he present his solutions. I discuss them below, but first let’s look at what Krugman says caused the great recession.
Cyclical versus secular problems
Krugman has an exceptionally polarized political view: Few good ideas emanate from Republicans, and he faults Democrats mainly for bowing to pressure from them. If you’re willing to divorce yourself from his politics – whether or not you agree with him – you’ll find his economic narrative informative and reasonably accurate.
Indeed, I agree with most of Krugman’s diagnosis, with one important exception.
Krugman claims that our economy has a problem that is “relatively trivial and quickly and easily fixed” in a way that would not be painful for most people. The problem is that we are “suffering from a severe lack of demand,” he writes.
Krugman says we have the equivalent of what Keynes called “magneto trouble.” In the 1930s, Keynes wrote that lack of demand in an economy is the equivalent of a faulty magneto (which today we call the alternator) in a car. You don’t need to buy a new car or overhaul the engine if only the magneto is faulty.
According to Krugman, those who say our problems have deep roots and no easy solution are “utterly wrong.”
The deep roots that Krugman referred to are what others call structural problems in the economy. Krugman denies that there is a structural problem in unemployment, citing, for example, that “only” 1.1 million construction workers lost jobs in the great recession.
But to dismiss losing that many jobs as a cyclical phenomenon is inaccurate. Those job losses are part of a larger, structural change that is unfolding in our work force.
To understand this, let’s go back to Krugman’s explanation for the end of the Great Depression: Government spending mobilized our military buildup for World War II, which allowed households to pay off their debt.
This explanation misses an important point, as I've written before. During the Depression, the agricultural sector of the U.S. economy, which was much larger than it is today, grew more productive, and the increased productivity relative to the demand for agricultural goods led to unemployment. What ended the Depression was the migration of workers from farms to cities, where they could be employed in the manufacturing sector.
Now we face a similar situation in manufacturing, where productivity has risen relative to demand. Add to this the fact that employment in the construction industry was driven by a housing bubble that has since deflated, and that jobs in many retail sectors benefited from consumer leverage that is no longer available, and you can see that the unemployment problem has a structural dimension.
Future job growth is much more likely to come from service industries like health care and education, and this structural change is missing from Krugman’s analysis.
Krugman’s simple and easy solution
Once it is clear that we face a structural problem in the workforce, then it follows that there can be no quick and easy solution that brings us back to full employment. Krugman, however, says that “ending this depression should be, could be, almost incredibly easy.”
Krugman’s solution is comprised of three steps: Additional fiscal stimulus, an increase in the target inflation rate and government assistance for mortgage refinancing.
Fiscal stimulus
Krugman claims the $787 billion American Recovery and Reinvestment Act (ARRA) from 2009 was too small. “The Obama administration did the right thing but on a wholly inadequate scale,” he says.
Krugman’s focus is clearly on providing a sufficiently large enough stimulus to drive demand. “Spending creates demand, whatever it’s for,” he writes. Only on page 215 is there a brief discussion of how that money should be spent, and Krugman does not offer any framework or criteria for deciding which projects should be funded.
I agree with Krugman that government spending should be an important ingredient to our recovery, but his lack of analysis on specific spending programs is distressing. He quotes Joseph Stiglitz, who said the ARRA was “badly designed and not big enough” and it is the bad design that needs to be fixed.
For example, Krugman calls for the rehiring of approximately 600,000 public-sector employees who lost jobs during the great recession, approximately half of them teachers. That alone, he claims, would nearly solve the unemployment crisis. But Krugman provides little data or analysis to demonstrate that those employees would grow the economy in the long run. Nor does he acknowledge that our states and cities face an underfunded pension crisis, which his plan would surely make worse. We need to provide better public education, but to simply rehire workers who were recently laid off is far too shortsighted.
Monetary policy
Because we are in a “liquidity trap,” the Fed cannot lower interest rates, which are already virtually zero. Krugman’s alternative recommendation is for the Fed to increase its higher inflation target from 2% to 4%, which in turn would force real (inflation-adjusted) interest rates further negative.
Higher inflation – or at least the expectation of it – would stimulate demand, because consumers would have the incentive to purchase goods before the price goes up. It would also allow the government to repay its debt with inflated and less costly dollars.
Raghuram Rajan, an economist at the University of Chicago, provided a rebuttal to this argument. (Incidentally, Rajan is one of several economists that Krugman repeatedly criticizes in his book.) Rajan’s argument is that negative real rates might not stimulate spending, but instead could incent investors to save more, fearing that low nominal interest rates would persist. Or they could push investors – like pension funds – into unnecessarily risky assets.
Rajan also touches on another possibility: that such a move could trigger a damaging rise in nominal rates. Gluskin Sheff’s David Rosenberg has shown that Fed policy has – by far – the highest correlation to interest rates. If a shift in policy were to trigger a rise in nominal rates, it would have far-reaching effects on the housing market, business investment and the government’s ability to service its debt.
The housing market
Krugman argues for government assistance for homeowners seeking to refinance their homes, with a more aggressive approach than was taken in the HAMP program. The most persuasive arguments I’ve heard to bolster housing have been for principal reductions that avoid moral hazard problems (you don’t want to reduce a delinquent homeowner’s principal when his neighbor – who is current on his mortgage – doesn’t get a similar benefit). I’ll leave it to others to decide if Krugman’s housing recommendations have merit.
Putting Americans back to work
Krugman rightly calls the unemployment situation in the U.S. an “immense human disaster” that threatens the long-run potential of the U.S. economy. He is equally right that the government – through fiscal policy measures – should act to address this crisis. That hasn’t happened yet.
Krugman is also at least partially right when he says that “warnings of some kind of debt crisis are based on nothing much at all” and that “this is really not a good time to obsess over deficits.” Low nominal and real interest rates are signaling that the market does not expect rapid economic growth and that this is a good time for the government to borrow.
But if it does, the government must spend wisely. If spending goes toward projects that do not produce competitive returns on capital, we will face the debt crisis that Krugman now dismisses. We need to spend on infrastructure, as Woody Brock advocates, in a framework that ensures only those projects that make economic sense get funding.
Krugman, on the other hand, wants as much fiscal spending as possible, without providing a framework to assess the virtues of specific programs. That will be very expensive, with little hope of solving the structural unemployment problems we face.
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