Paul Krugman: Make economic policy based on overwhelming evidence not fantasy

In his column, Professor Paul Krugman calls for making economic policy based on overwhelming evidence and not fantasy.

If his advice were followed, we would never adopt the Japanese Model for handling a bank solvency led financial crisis, but rather would implement the Swedish Model.

The overwhelming evidence, with Iceland as the latest example, is that implementing the Swedish Model and requiring the banks to recognize upfront the losses that they would ultimately realize if the bad debt in the financial system worked its way through the long process of default and foreclosure results in a rapid recovery from the financial crisis.

There is also overwhelming evidence, with the EU, Japan, UK and US as the latest examples, that implementing the Japanese Model and protecting bank book capital levels and banker bonuses at all costs results in long periods of Japanese-style economic slump.

That the evidence supports the Swedish Model and rejects the Japanese Model is not surprising.

Under the Swedish Model, the banks absorbing the losses protects the real economy.  Under the Japanese Model, the burden of the excess debt is shifted onto the real economy.  Cash flow that would be used to support reinvestment and growth in the real economy is instead used to make debt service payments.

Given that Professor Krugman believes that economic policy should be based on overwhelming evidence, it is surprising that he doesn't discuss the need for adopting the Swedish Model.

Why is recovery from a financial crisis slow? 

Financial crises are preceded by credit bubbles; when those bubbles burst, many families and/or companies are left with high levels of debt, which force them to slash their spending. This slashed spending, in turn, depresses the economy as a whole. 

And the usual response to recession, cutting interest rates to encourage spending, isn’t adequate. Many families simply can’t spend more, and interest rates can be cut only so far – namely, to zero but not below.

Does this mean that nothing can be done to avoid a protracted slump after a financial crisis? No, it just means that you have to do more than just cut interest rates.

A recovery from a financial crisis doesn't have to be slow if the Swedish Model is adopted and the banks recognize the losses on the excess debt upfront.

When banks recognize the losses, families and companies have their debt levels adjusted to what they can afford to pay.  As a result, families and companies do not have to slash their spending and the real economy is protected.

In particular, what the economy really needs after a financial crisis is a temporary increase in government spending, to sustain employment while the private sector repairs its balance sheet. 

And Obama did some of that, blunting the severity of the financial crisis. Unfortunately, the stimulus was both too small and too short-lived, partly because of administration errors but mainly because of Republican obstruction.

Had the Obama administration required the banks to recognize the losses on the excess debt, the private sector's balance sheet would have been repaired.

Then, the fiscal stimulus would really have kicked the economy into high gear.

Over the past few months advisers to the Romney campaign have mounted a furious assault on the notion that financial-crisis recessions are different. 

In July former senator Phil Gramm and Columbia’s Republican Glenn Hubbard published an article claiming we should be having a recovery comparable to the bounce back from the 1981-82 recession, while a white paper from Romney advisers argues that the only thing preventing a rip-roaring boom is the uncertainty created by Obama.... 

The main point, however, is that the Romney team is wilfully, nakedly, distorting the record, leading Reinhart and Rogoff – who aren’t affiliated with either campaign – to protest against “gross misinterpretations of the facts.” And this should worry you. 

Look, economics isn’t as much of a science as we’d like. But when there’s overwhelming evidence for an economic proposition – as there is for the proposition that financial-crisis recessions are different – we have the right to expect politicians and their advisers to respect that evidence. Otherwise, they’ll end up making policy based on fantasies rather than grappling with reality.

The overwhelming evidence is that the correct response is to adopt the Swedish Model, require the banks to recognize the losses upfront, implement fiscal stimulus and bring transparency to all the opaque corners of the financial system so that a financial crisis doesn't happen again.

This response was first done by the FDR Administration and it broke the back of the Great Depression.