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‘Depression economics’

July 15, 2012

FOUR years down the road, politicians and economists remain deeply divided on policies and framework for coming out of depression.

There are the ones propagating the Keynes view of stimulating the economy through government spending; and then there are those who are all for austerity measures.

Paul Krugman in his latest book “End this depression now” presents solutions for economic recovery of America and other advanced countries. He steers the conversation back to job creation and fiscal stimulus from deficits reduction and spending cuts.

Being a Keynesian, he reiterates that boom not slump is the time for austerity and illustrates how austerity programmes diminish economic growth. Britain which followed strict austerity measures hasn’t set the world on fire, he claims.

Despite on and off claims of economic recovery and financial stabilisation, the unemployment figures remain over eight per cent in the US. Across the Atlantic, the eurozone stumbles from crisis to crisis.

United States (as well as EU) needs strong leadership to build support for stimulus policies —e.g., large-scale job creation, debt relief and the reversal of current austerities — on a more expansive scale.

Strong measures that would all go a long way toward lifting developing economies out of this depression should include, among other policies, increased federal aid to state and local governments.

Krugman writes that with federal aid to reverse budget cuts, state and local governments could be spending $300 billion a year that would create more than a million direct jobs and possibly up to three million jobs when indirect effects are taken into account.

Secondly, a more aggressive approach by the Federal Reserve to quantitative easing is needed. An inflation target of four per cent as opposed to around two per cent would have multiple benefits of reducing the debt burden, making borrowing attractive, and solve the problem of inelasticity of wages.

Thirdly, a less timid effort by the Obama administration to reduce homeowner debt through ‘a programme of mass refinancing’ will have the necessary effect of stimulating demand.

The debt relief programme offered was too complicated to have any real effect and left a lot to be desired.

Other solutions include environmental regulations boosting the renewable energy sector and incentivising energy efficiency upgrades; taking a tougher line with currency manipulating countries. Krugman admits that all suggested theoretical effort may not produce the desired results but US Fed having ‘Rooseveltian resolve to do whatever is necessary’ by being ‘aggressive and experimental’ is what is needed.

The author disagrees with three main objections of his suggested policies: that government spending programmes don’t work, that increasing deficits undermine business confidence and that there aren’t enough quality projects in which to invest.

Whilst the Obama Administration’s American Recovery and Reinvestment Act had a price tag of $787 billion, the amount wasn’t enough for the size of the US economy. Also, 40 per cent of the total consisted of tax cuts, which are less effective in stimulating demand. Upgradation of crumbling infrastructure creates direct jobs. Providing tax cuts on the other hand doesn’t stimulate investment due to lack of demand and business confidence.

Despite increasing deficit and a cut in S&Ps downgrade of US debt from AAA to AA, the interest rates remain close to zero and safe haven status of US treasuries hasn’t changed.

Given that the private sector is, in classical Keynesian view, stuck in a ‘liquidity trap’ where even zero interest rates don’t motivate businessmen to take on projects and they keep on saving.

Hence, government spending must be a significant part of the solution.

Although Krugman presents a strong case for Keynesian economics, his recommendations are debatable indeed. The rise in unemployment has it’s due contribution from inadequate demand, but structural changes like the substitution of cheap foreign workers and innovative technology ( that sheds some jobs) has played its role as well.

The advocates for austerians may be excessively fearful of so-called ‘bond vigilantes,’ -those bond market investors who sell off their investments in response to perceived inflationary pressures thus decreasing the yields - but health of a government’s finances has to kept in mind.

Inflation imposes real costs, for instance on retired baby boomers reliant on fixed dollar annuities and on foreign investors in government bonds.

Bondholders might shift away from the dollar or euro to other currencies or to alternatives like gold. It would increase the risk of the dollar losing its status as the world’s reserve currency, with potentially serious political consequences like competitive devaluations, accusations of currency manipulation, trade wars etc.

The author has brought the focus back to the right objective i.e. the plight of the common man should end now and he argues that the world should not forget the lessons from history — the Great Depression of the 1930s. The question is, however, will the solutions of the past be a perfect fit in the 21st century as well?