Since the beginning of the financial crisis, Professor Krugman has been advocating that governments should be adopting aggressive economic stimulus policies. The idea being that with a big increase in economic growth, the economy can afford to repay the current excess debt in the financial system.
Professor Krugman has made a number of very public statement that support his claim to being a Cassandra with regards to our ongoing financial crisis. These include his statements that Obama's stimulus was not going to be successful because it was not big enough.
Unfortunately, these statements do not make him a Cassandra. Like all but a small handful of his peers in the economic profession, Professor Krugman was absent when it came to predicting the financial crisis and offering a solution beforehand to mitigate the impact of the crisis.
Yes, his predictions about the policies failing were accurate. However, the reasons that he gives as to why the policies failed are limited and do not really explain the totality of why the global economy has failed to revive.
There is an alternative explanation that also predicts these policies, both stimulus and austerity, would fail. This explanation also suggests policies which if implemented, unlike Professor Krugman's, would end the financial crisis.
Regular readers know that your humble blogger used this alternative explanation to predict the financial crisis. I also offered a solution, the Swedish model with ultra transparency, to mitigate the impact of the financial crisis. Equally importantly, I have continued to make predictions about the success or rather the lack of success of the various policy responses, like stimulus, austerity and zero interest rate policies, and these predictions have also come to pass.
For example, I predicted that the economy would remain in a downward spiral until such time as opacity was eliminated in all the corners of the financial markets (including structured finance securities and bank balance sheets). Even with Obama's fiscal stimulus, this trend continues (Professor Krugman might choose to argue this, however, the fact that every time fiscal or monetary stimulus is stopped, the economy stalls and heads towards recession confirms the underlying trend).
Professor Krugman has been pounding the table to call attention to his solution. However, by itself, his solution will not address what is undermining the real economy. The real economy is in a downward spiral as a result of the excess debt in the financial system and all the related distortions in pricing caused by the regulatory and monetary policy responses to the financial crisis.
Until such time as it is easier for a creditworthy borrower to get a loan than a zombie borrower, no amount of fiscal stimulus is going to end the financial crisis.
The only thing that will end the financial crisis is forcing the banks to recognize the losses hidden on and off their balance sheets and requiring the banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details to confirm this.
Now I happen to believe that combining Professor Krugman's call for fiscal stimulus with the Swedish model and ultra transparency is a good idea. That is why it is in the blueprint for saving the financial system.
What Professor Krugman has achieved with his table pounding is to make it harder to focus attention on the blueprint and end this financial crisis.
Deregulation of financial services was supposed to have made us all better off, so why did most of us have to live off credit to keep up? Now that it has all gone wrong, and everyone agrees we're in the worst crisis since the Great Depression, why aren't we following the lessons we learned in the 1930s?Excellent question as the number one lesson from the 1930s was the introduction of transparency into the financial system. Specifically, the FDR Administration rebuilt the financial system based on the philosophy of disclosure and ensuring that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could make a fully informed investment decision.
President Obama is the only world leader who has attempted a Keynesian stimulus programme. Why has it been only minimally effective?Doesn't address the losses hidden on and off the banks' balance sheets.
Why do most other western leaders still insist the only way out is to tighten our belts and pay off our debts, when that clearly isn't working either?Because most western leaders have adopted the Japanese model for handling a bank solvency led financial crisis and are trying to protect the bank's book capital levels. If we stop paying our debts, the capital levels take a big hit.
And how come the bankers, credit agencies and bond traders are still treated with cowed reverence – don't frighten the markets! – when they got us into this mess?When you spend as much money as they do on lobbyists, academics and jobs for former regulators and policymakers, you tend to get what you want.
An authority on John Maynard Keynes, Krugman wrote a book in 1999 called The Return of Depression Economics, largely about the Japanese slump, which drew ominous parallels between Japan's economic strategy and the pre-New Deal policies of the early 30s that turned a recession into catastrophic depression. At the time, unsurprisingly, most western economists weren't bowled over; in thrall to the seemingly endless boom, the Great Depression looked to them to be more or less irrelevant. Krugman's latest book will be much harder to ignore.He is right that the Japanese model should never be adopted as the only beneficiaries are the bankers.
He doesn't expect it will be an easy message to sell, though. "As far as I can make out, the serious opposition to the coalition's policy is basically a half-dozen economists, and it looks as if I'm one of them – which is really weird," he laughs, "since I'm not even here."
Visiting London last week, he met lots of what he calls Very Serious People: "And there are lots of things these people say that sound very wise and sensible. But it's all upside-down; it's all wrong. Yet the power of their orthodoxy – even when it's failing – is quite awesome."
These Very Serious People present economics as a morality play, in which debt is a sin, and we have all sinned, so now we must all pay the price by tightening our belts together. They tell us the crisis will take a long time to resolve, and must inevitably be painful.
All of this, according to Krugman, is the opposite of the truth. Austerity is a self-imposed collective punishment that is not just unnecessary, but won't work. We know what would work – but for complex political and historical reasons that his book explores, we have chosen to forget. "Ending this depression," he writes, "should be, could be, almost incredibly easy. So why aren't we doing it?"...Because we have economists who didn't predict the crisis (see the Queen's Question) pro-offering their solution without understanding what is really driving the crisis.
Thus far, Krugman has essentially restated the case for Keynesianism. "And these are not hard concepts, actually. It's not hard to get it across to an audience. But it doesn't seem to play in the political sphere." What's fascinating is his historical analysis of why policy-makers, who once understood these principles, collectively decided to forget them.
In the years following the Great Depression, governments imposed regulatory rules upon the banking system to ensure that we could never again become indebted enough to make us vulnerable to a crisis. "But if it's been a long time since the last major economic crisis, people get careless about debt; they forget the risks. Bankers go to politicians and say: 'We don't need these pesky regulations,' and the politicians say: 'You're right – nothing bad has happened for a while.'"
That process began in earnest in 1980, under President Reagan. One by one the regulations on banking were lifted, until "we lost the safeguards, and it meant there was an increasingly wild and woolly financial system willing to lend lots of money". Politicians were in part persuaded to deregulate by the argument that it would make us all richer. And to this day, "there's this very widespread belief that there was, in fact, a great acceleration in growth. But this really isn't hard. You sit down for a minute with the national account statistics, and you see it ain't so."
If we divide the period between the second world war and 2008 into two halves, "the first half is a really dramatic improvement to living standards, and the second half is not."...
Why would economists claim ordinary people were getting much richer if they weren't? "The answer, I think, has to be that you need to ask: 'Well who are the people who say these things hanging out with? What is their social circle?' And if you're a finance professor at the University of Chicago, the people that you're likely to meet from the alleged real world are going to be people from Wall Street – for whom the past 30 years have, in fact, been wonderful. If you're a mover and shaker in the UK, you're probably hanging out with people from the City. I think that is the story of the disconnect."...Or perhaps economists were being hired as consultants by Wall Street and as any good consultant knows, you give the client what they ask for.
There were early warning signs, such as the savings and loans crisis of the late 80s, that should have alerted politicians to the dangers of financial deregulation, moral hazard and subsequent spiralling debt. But by then Wall Street's influence over policy-makers had rendered them deaf to alarm bells – in part because bankers were financing so many politicians' campaigns.
Krugman quotes Upton Sinclair's famous observation: "It's difficult to get a man to understand something, when his salary depends on his not understanding it" – but more than that, he suspects the sheer glamour of wealthy bankers had a powerful influence over politicians.
"My impression is that old style captains of industry can be rather boring. I'm not sure how much thrill there is in hanging out with someone like that. But Wall Street people are in fact very smart; they're funny, they're not company men who work their way up the chain. They're impressive."This is why it is virtually impossible to get policy-makers to consider the Swedish model with ultra transparency.
Since the crash Krugman has become the undisputed Cassandra of academia, but he jokes: "I'm kind of sick of being Cassandra. I'd like to actually win for once, instead of being vindicated by the disaster coming – as predicted. I'd like to see my arguments about preventing the disaster taken into account instead."That makes two of us. Any time you would like to actually end this financial crisis, I look forward to hearing from you Professor Krugman.