Friday, December 12, 2008

Krugman's Solution

Cross-posted at Swords Crossed

In his article titled "What to Do" in this month's edition of The New York Review of Books, Paul Krugman explains how we can get out of our current economic debacle and how to prevent another from happening in the future.  First he clearly explains the path we must take to correct our situation.  It consists of two major drives:

What the world needs right now is a rescue operation. The global credit system is in a state of paralysis, and a global slump is building momentum as I write this. Reform of the weaknesses that made this crisis possible is essential, but it can wait a little while. First, we need to deal with the clear and present danger. To do this, policymakers around the world need to do two things: get credit flowing again and prop up spending.

He then discusses the struggle of trying to get the credit markets to reopen.  He explains that it is imperative to look to history for examples of how other countries were able to open the credit markets in times of crises.

The obvious solution is to put in more capital. In fact, that's a standard response in financial crises. In 1933 the Roosevelt administration used the Reconstruction Finance Corporation to recapitalize banks by buying preferred stock—stock that had priority over common stock in terms of its claims on profits. When Sweden experienced a financial crisis in the early 1990s, the government stepped in and provided the banks with additional capital equal to 4 percent of the country's GDP—the equivalent of about $600 billion for the United States today—in return for a partial ownership. When Japan moved to rescue its banks in 1998, it purchased more than $500 billion in preferred stock, the equivalent relative to GDP of around a $2 trillion capital injection in the United States. In each case, the provision of capital helped restore the ability of banks to lend, and unfroze the credit markets.

He claims the initial recovery plan, the $700 billion proposed to buy the troubled assets was fraught with error in its application.

Yet it was never clear how this was supposed to help the situation. (If the Treasury paid market value, it would do little to help the banks' capital position, while if it paid above-market value it would stand accused of throwing taxpayers' money away.)

The only concern he has about the current plan for the $700 billion is that it is too small of an amount to make a substantive difference. Instead, he believes we need to follow Japan's path and fork over 4% of our current GDP. This process must be completed in conjunction with European bailouts of the same kind and help to developing countries also. He concludes this section with the rebuttal to the anticipated accusation thrown at this type of solution by freemarket critics.

But for now the important thing is to loosen up credit by any means at hand, without getting tied up in ideological knots. Nothing could be worse than failing to do what's necessary out of fear that acting to save the financial system is somehow "socialist."

After credit gets flowing, we need spending. He proposes a Keynesian fiscal stimulus plan to jump-start the economy. He says giving tax breaks and sending rebate checks (like the stimulus package to taxpayers earlier this year) will not work because there is no guarantee that this money will be spent; instead people will likely save and sit on the money. To prevent this, he recommends a public works project to repair our infrastructure. The reasons to go this route are twofold:

. . . it has two great advantages over tax breaks. On one side, the money would actually be spent; on the other, something of value (e.g., bridges that don't fall down) would be created.

He finishes his article with preventative measures to prevent this crisis from happening again. He argues we need to stretch the regulations in place for banks to those non-bank institutions that essentially created a banking crisis. We also need to put in place safeguards for international capital flows like we did during the Asian monetary crisis of the 1990s.

We're also going to have to think hard about how to deal with financial globalization. In the aftermath of the Asian crisis of the 1990s, there were some calls for long-term restrictions on international capital flows, not just temporary controls in times of crisis. For the most part these calls were rejected in favor of a strategy of building up large foreign exchange reserves that were supposed to stave off future crises. Now it seems that this strategy didn't work. For countries like Brazil and Korea, it must seem like a nightmare: after all that they've done, they're going through the 1990s crisis all over again. Exactly what form the next response should take isn't clear, but financial globalization has definitely turned out to be even more dangerous than we realized.

He concludes the article with the hopeful tone that we have an unlimited amount of our most beneficial resource: ideas and innovation.

We will not achieve the understanding we need, however, unless we are willing to think clearly about our problems and to follow those thoughts wherever they lead. Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.

He understands that these are times when we need tried and true solutions over the status-quo, action over bickering and debate, and most of all practicality and understanding over ideology.

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