Monday, January 5, 2009

Fighting Off Depression

Paul Krugman writes today in The New York Times about what the new administration should do to fight off a depression. Krugman believes that large-scale Keynesian deficit spending is what is needed in a situation like the current one. He also rejects the Friedmanite theory that capital injections into banks can be a way to fight off a depression.

Krugman is certainly a decent economic thinker, but he is not known for his consistency. He used to advocate capital injections into banks, but is now apparently against those. He used to call Thomas Frank’s theories on the so-called “Southern Strategy” “erroneous” (theories having to do with poor people voting for Republicans, even though that goes against their economic self-interest), whereas he now writes about them all the time, as if he came up with them himself. Krugman, like Bernanke, lacks an ideological determination and clarity of vision.

Now, I agree that something has to be done to try to avoid a depression, but things are more complicated than Krugman make them seem. First of all, Keynesian spending is just a band-aid approach. Second, Friedmanite bank capital injections usually work, but only if they are highly controlled by the government. Third, a depression in The United States is something very different compared to a depression in every other industrialized country, because The United States does not have a social safety net.

Short-term solutions is without question the usual name of the game in terms of American politics, and also in terms of American academic economics. As I wrote in my last post, ideology is absent from American politics. If the government does not have a clear-cut ideological vision, a series of band-aid approaches tends to dominate politics. The result is the same if the ideological conviction is a conservative one, in which case (according to conservatism) band-aid approaches constitute the second-best solution, second only to doing nothing. Keynesian spending can indeed provide some short-term relief if a depression is looming. Perhaps more than anything, it can provide a “psychological stimulus”, where people see other people working, building things, and things happening in general. This can bring back confidence in the system. The question that I’m asking, however, is: should confidence in the system be quickly brought back by Keynesian spending?

I would argue that the problems we are experiencing today are much deeper than a problem of confidence. To apply a series of band-aid approaches so that we could go on as before would be a grave mistake. Like I said, there is nothing wrong with spending during a crisis per se, but you should never spend money you don’t have. Spending is good, deficit spending is bad.

I turn again to Sweden, that went through a very, very similar crisis in the early 90s. Sweden had tried the Keynesian model for 30 years, but ultimately rejected it when it became clear that it was artificially supporting a system that was not sustainable. That system came to an end in the early 80s. With these lessons in mind when the crisis came, the Parliament worked out a crisis package with broad, multi-party (yes, there are more than just two parties in Sweden…) support. The solution, thought the government, was not deficit spending, but:

1. spending reduction,

2. capital injections into banks (where the government took control of those banks, not just gave away the money like a bunch of idiots…) and,

3. Long-term commitment to budget surplus and a pay-as-you-go system for government spending

This may sound like some type of anti-government Republican credo, but keep in mind that government spending makes up over 40% of GDP in that country, whereas it makes up less than half that in The United States. Let me say this once and for all: sound fiscal policies should have nothing to do with what ideology you subscribe to.

Number 1 and 2 in the list above were meant to stave off the crisis, but by no means quickly get rid of it and continue like before. The government realized that something had to give, and the recovery was painful, but real. The third action, or commitment, was actually realized, and it was meant to set the country up in such a way that the next big crisis would be easier to get through.

This is exactly what ended up happening. To be sure, Sweden is currently going through a lot of pain and job losses, but the government’s coffers are full because budget surpluses for over 10 years have created a readiness for the crisis that we see today. As a result, Sweden can use the surplus that has been built up to spend its way out of the crisis without running a deficit. That’s the beauty of the whole thing: you achieve crisis relief without setting the country up for the next crisis by means of deficits, loans, and all the rest of it.

The United States now has a chance to set the country up in the same way that Sweden did in the early 90s. By doing that, the country will be more sustainable in the future, and be able to weather the next crisis as Sweden weathers the current one now.


Edward S. Isaacs said...

The exact model used by FDR, and contrary common belief; it was NOT successful. This time around we're having close to (very)a national bankruptcy and 99% of the "experts" don't even know it.

Jacob said...

Yes, you're right. I believe that the Swedish model is the one that should be used. In fact, when this crisis started, the former Swedish minister of finance, Bo Lundgren, who dealt with the crisis there in the early 90s, offered to testify before Congress to help out.

They should have taken him up on his offer. Maybe then we wouldn't have gotten the mistake of the century: the TARP plan.