Monday, December 8, 2008

Paul Krugman on what to do next

Paul Krugman says it is important to immediately get credit flowing again and prop up spending. He feels that the $700 bn recapitalization plan of the US Treasury may be too little too late for three reasons - it is too small (relative to the GDP) compared to the requirements, it's unclear how much of the bailout will reach the components of the shadow banking system (largely unregulated financial organizations including investment banks and hedge funds) that are at the core of the problem, and it is not certain whether banks will be willing to lend out the funds, as opposed to sitting on them.

He predicts that the capital injections will get bigger and more interventionist, something similar to a "full temporary nationalization of a significant part of the financial system". He approves of the Fed's decision to expand its window to accept Commercial Paper (CP) as collateral for its lendings, as being especially important at a time when businesses are getting squeezed off credit. He also feels that given teh globalized and deeply integrated nature of the global financial markets, all such actions should be taken in concert with the major economies of the world. All this should be accompanied with efforts to prevent the contain of the crisis to the emerging economies.

The issue of addressing the global economic slump, is sought to be done through old-fashioned Keynesian fiscal stimulus. Here Krugman argues that the first round of stimulus in US failed because it was too small and ficussed too much on ineffective tax credits. He feels that any new stimulus should focus on sustaining and expanding government spending—sustaining it by providing aid to state and local governments, expanding it with spending on roads, bridges, and other forms of infrastructure.

Paul Krugman's suggestions are mostly informed by the bitter experiences of the Great Depression and the Japanese economic crisis of the nineties. It is alleged that in both cases, the Governments may have done too little too late, and allowed the economic situation to deteriorate into a condition from where retrieval was long drawn out and painstaking.

This line of reasoning appears to be dictated more by a forlorn hope than any objective and rational considerations. Krugman himself makes it clear by writing that we should "approach the current crisis in the spirit that we'll do whatever it takes to turn things around; if what has been done so far isn't enough, do more and do something different, until credit starts to flow and the real economy starts to recover". This is one of the few occasions, I have reservations about what Paul Krugman is advocating, and will elaborate on it in my next post.

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