• by Matthew Berger (london)
• Saturday, June 13, 2009
• Inter Press Service

It is too optimistic to say the United States is headed for a Japan-style recession, according to Nobel laureate Paul Krugman.

Delivering a series of lectures at the London School of Economics Tuesday through Thursday, Krugman tried to explain the myopia of economists in predicting the crisis, the inability of knowing when it will end, and why conventional economics will need to change drastically as a field in order to remain relevant.

In the face of such uncertainty, history is one of the few reliable sources of insight, and he set the tone early Tuesday, starting off with slides showing how the current recession is looking a lot like the United States' Great Depression of the 1930s.

'Quantitatively, at least the first year is a lot like the Great Depression,' he said. 'World industrial output has so far fallen just as fast.'

The Federal Reserve, he explained, faced the same situation at the beginning of the current crisis as Japan did during the 1990s, namely the impotence of the monetary tools normally used to fight off recession.

Japan’s recession was not terrible; there was no mass unemployment, no blood in the streets. But it was intensely frustrating because it could not be fixed with the usual prescription, he said.

Normally, the prescription is to reduce short-term interest rates, which the Japanese central bank did until they were virtually at zero, as the U.S.’s are today. Cutting these interest rates increases the supply of money, which increases the liquidity of money and the extent to which that money is lent out. But if rates are at zero the demand for that money is already saturated.

This is the liquidity trap Japan faced, and the U.S. Federal Reserve now finds itself in the same situation today; U.S. short-term interest rates are now around 0.27 percent.

'We are deep in a liquidity trap and I hope we won’t be 10 years from now, but I have my concerns about that,' Krugman said.

Following Tuesday’s talk, many U.S. stocks experienced a late rally in response to his statement that he 'would not be surprised if the official end of the U.S. recession ends up being, in retrospect, dated sometime this summer.'

Krugman was speaking only of the official ending of the recession, however, which he explained would happen as soon as the first indicator begins to go up.

The clear overall message of his lectures was much darker. Citing the U.S. unemployment rate of 9.4 percent for the month of May – the highest in 26 years – Krugman said 'I never thought I was going to see that again in my lifetime. Almost surely unemployment will keep rising for a long time.'

Despite his ominous message, the early evening lectures all maintained a light tone. Far more than any sort of pessimism, Krugman seemed to convey wonderment at the magnitude of the crisis and the ways in which it will reshape economic thinking. Despite the dismal job prospects for the students in the room, there was also a sense of an opportunity to reshape the discipline of economics.

He detailed how Keynesian economics has gradually fallen out of favour and been significantly distorted over the past 30 years. But the ideas of John Maynard Keynes (1883-1946) and those few who have truly stuck to his gospel – he emphasised Hyman Minsky in particular – have become increasingly relevant today, as they were the only ones to predict the present disaster.

While he acknowledged the crisis’s origins in a housing bubble, he said the reason it was overlooked as a serious problem by many was because we still expect banks 'to look like something Jimmy Stewart would run.'

Instead, a shadow banking system crept into existence alongside the brick-and-mortar institutions. While there was never a run on these more familiar banks leading up to this crisis, there clearly was on the shadow banks, creating a replay of Depression-esque bank failures that, however, looked nothing of the sort.

He was careful to emphasise that he could not know what the key to exiting the crisis might be, but he offered a few suggestions over the course of the three lectures.

Since cutting interest rates no longer leads to an increase in investment, government spending, even at the cost of government indebtedness, is one of the best routes out of today’s liquidity trap, he said. With little to be invested in, savings are currently stagnating, but government spending gives savings somewhere to go and so should have an expansionary impact on the economy.

Contrary to cries for 'fiscal responsibility' on the part of governments, this spending, he said, is not only good for us now but ultimately good for us long-term. 'This borrowing is actually reducing the extent to which we’re impoverishing ourselves,' he said.

Another beneficial route, he cautiously suggested, might be higher inflation than before the crisis. Inflation causes debt, in real terms, to diminish and would allow real interest rates to dip below the zero percent threshold, thus maybe allowing the negative five percent interest rate currently needed to bring world savings in line with world investment and to achieve full employment.

Ideally, though, and much easier to sell than inflation, recovery would be driven by exports, but Krugman said this option is not on the table today 'unless we can find another planet to export to.'

In any case, the period of recovery might be a long way off yet. 'Japan’s recession might start to look good in terms of duration,' he warned. 'It’s hard to know how this all ends.'

© Inter Press Service (2009) — All Rights Reserved. Original source: Inter Press Service

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