“What a time for anyone interested in economics,” began Paul Krugman’s keynote address to the CIGI’09 conference attendees gathered to discuss the global economic crisis.
Dr. Krugman, the Nobel laureate, Princeton University professor and New York Times op-ed columnist, said there isn’t anyone the crisis hasn’t affected. He also emphasized that it’s not over. While the acute phase is probably over and the fears of a second depression have passed, there could have been a depression. “Avoiding a depression is not enough,” he said. US government projections, which estimate a full recovery in about 5 years, would put unemployment at just below 6 percent.
Dr. Krugman expressed his concern over a prolonged period of economic weakness. Even during Japan’s “lost decade,” the country never had as bad a year as the current crisis. The crisis is a cautionary tale: Japan, an advanced, industrial country with stable government, couldn’t pull itself out of stagnation. Comparing the current US dilemma with Japan, he said the US suffered from a balance sheet crisis with household sector debt, while Japan had struggled with corporate sector debt.
The financial crisis will have prolonged long-term effects on the economy. It is hard to see how we’ll have full recovery, he explained, given that the excess of savings is greater than businesses’ willingness to invest.
“It’s not clear where the driver is,” Dr. Krugman said. “We may be stuck in the woods for some time in the current trajectory.”
A surge in business investment would help. He also had some hope with response to the environment and climate change, though green technology is speculative. Economies with relatively low imports of GDP perform better with fiscal stimulus.
The underlying problems included a runaway financial sector with too much financial activity; big growth in real executive stuff (salaries and bonuses), which exploded; the failure to channel savings into productive uses, which increased systemic risks. And, the banking system outgrew regulation, by changing to make the old regulations outdated.
While the housing bubble was clear to him, Dr. Krugman acknowledged that he thought the banking sector was safe. The bank doesn’t have to be a building, he said, it can be anyone who borrows short and sells long. Unlike the bank runs of 1930-1932, the current crisis is not an exotic one. It is people clicking on their computer mouse trying to regain short-term assets.
In 2003, newspapers printed photos symbolizing the cutting up of banking regulations. Changes in the banking system with loosening of regulations meant lowered risk standards for borrowers. Most of the consequences of the crisis were due to innovations and attitude, Dr. Krugman explained. There was celebration of the changes rather than concern about increased exposure.
He doesn’t consider international imbalances to be the core issue. Former US President Ronald Reagan and British Prime Minister Margaret Thatcher initiated the spirit of regulation that primed the US for the crisis. China’s reserves are a new phenomenon; previously, there were balanced. China also had a fixed exchange rate and nothing forced them to stop doing so.
While the US gets a bad rap in the crisis, Dr. Krugman pointed out that Spain and the UK, for example, have bigger housing bubbles. The collapse of the European bubble is as big a contributor as the US one. Regional economies have suffered more, particularly those who have large exports of durable goods. Michigan and Ontario, for example, are not part of the problem, they are victims.
“It was an incredibly synchronized crisis,” he said. And it was inevitable.
The global financial system grew beyond understanding and policing, he explained. The world is now struggling to achieve recovery, and there are no role models for it. The Great Depression ended with the huge fiscal stimulus of World War II, which is not the model desired. Institutional arrangements are inadequate to either prevent a crisis or to deal with one if it occurs. International spillovers in fiscal policy are a huge problem, he said.
Dr. Krugman called for international cooperation and policy coordination for solutions and arrangements. The G20 may be the place. He cited the need for vastly better regulation of financial intermediaries to limit leverage, and the need to determine which institutions are systemic. He also spoke about moral hazard and the need to change executive compensation, though he said it would be a hard fight to much regulation. Dr. Krugman also mentioned the need for better arrangements for international liquidity/lender of last resort. Everything we’ve seen before was happening at the same time, he said, and is enormously contingent on personalities.
Inflation targets need to be somewhat higher, around 4 percent, he said. This would provide more room for cuts during a crisis. The current crisis has proven this to be valid. Dr. Krugman posited that within a higher inflation target there would have been a more effective policy response —a zero interest rate is really binding.
To sum up, he articulated the need for these reforms: 1) the regulation of financial intermediaries; 2) international liquidity/lender of last resort arrangements; 3) international macro policy coordination; and 4) revised inflation targets.
“We need an international forum to make these things happen,” Dr. Krugman said. “We are heading for a world in which international coordination is needed.”
In closing, he highlighted the need to address environmental problems such as the spillover of CO2 emissions.
“If we can’t get enough cooperation to save the planet, nothing else matters,” he said.