24 August 2009,  Financial Times – Fund Management

When asked where the most promising investments for the short term are, Paul Krugman, the most recent recipient of the  Nobel prize for economics, candidly exclaims “damned if I know”.

But the Princeton economist is certain the US economy would be far worse off without the government’s massive $787bn (£476bn, €553bn) stimulus package.

“I can’t come up with any analysis that suggests a superior outcome without this level of deficit spending, both in the short and long run,” says Mr Krugman, “and the funding for this spending will eventually come from increased economic output and subsequent higher taxes when the economy can afford them.”

Massive government spending is essential for generating growth, according to Mr Krugman, who even fears the first stimulus package will not be enough to reduce unemployment and keep the economy from slipping back into recession.

Mr Krugman is an old fashioned Keynesian economist. He believes that any spending in the short-run, private or government, will produce short-run growth and jobs.

“Ideally, you’d rather get the most out of every dollar spent,” Mr Krugman qualifies, “but in terms of what spending will stimulate GDP in the third and fourth quarters, there isn’t good spending or bad spending. Anything that will lead to an increase in effective demand will restart the economy.”

Still, Mr Krugman has no idea if the current surge in equity markets is a response to actual recovery. He agrees with Nouriel Roubini’s variation of Paul Samuelson’s quip: that the stock market has forecasted six out of the last zero recoveries.

“The market is right where it was in January, when we were already in a severe economic crisis,” he observes.  All that’s happened is that the ‘end-of-the- world’ scenario has given way to a bit more realistic but still fairly negative view, with current valuations currently in line with historical trends.”

He is very certain, however, that to prevent a repeat of this crisis, financial institutions across the board will need to be more carefully regulated. “In a nutshell, anyone who borrows short and lends long and who offers safe assets for savers but invests in riskier products is in essence a bank and needs to be regulated like one.”

He would like all such institutions to meet bank-type capital requirements. They should have a well-defined set of government guarantees that apply to a wide range of assets, financed through an equally well-defined set of premiums, similar to those that US banks currently pay into the Federal Deposit Insurance Corporation, which help finance rescues when necessary.

Moreover, Mr Krugman argues, “the government needs to codify principles-based, not rules-based, policies.” This would make it harder for the financialindustry, with its very good lawyers, to find ways to evade legislative intent. Otherwise, Mr Krugman believes the financial system will remain prone to catastrophic meltdowns. While he thinks the health of larger banks has been somewhat stabilised, Mr Krugman is concerned that the Public-Private Investment Program, which was designed to remove toxic assets off their balance sheets, has so far been kind of a joke.

“There’s just not much happening,” he says, “as banks simply want to hold onto their assets for more than what people are willing to pay for them, even with the implicit subsidy the government is providing potential buyers.” And he is concerned that this problem could threaten the stability of the banking system if the economy fails to recover.

A second financial crisis could overwhelm smaller banks, which have not received the same government support that has sustained their larger brethren, he worries. He also fears the economy could fail to gain traction and slip into a deeper recession, especially if unemployment continues to rise and consumer spending continues to decline. He thinks there’s a risk that this economic malaise could simply drag on, Japanese style. And he is worried about wage deflation, and believes that a second stimulus package of $400bn-500bn will be necessary to sustain economic growth and avert the disastrous effects of deflation.

In contrast, he is not afraid under the present circumstances that a big increase in the monetary base necessarily implies future inflation. The Federal Reserve has not been printing vast quantities of money, he points out. It has been lending large amounts of money to the banks, which has led to a surge in bank reserves. So when banks start to lend again, all the Fed needs to do is to stop providing monetary support and start reeling in what they already allotted to the banks.

“However,” he cautions, “if banks start to shift these reserves out of the deposits of the Fed and into the economy, then the Fed would need to soak up the money either through borrowing or by selling off bank assets it has acquired.”

Given the media’s nonstop reporting on economic conditions, Mr Krugman counsels patience. According to a recent Goldman Sachs report, only $2bn, or less than two per cent of funds allocated to infrastructure, had actually been spent as of the end of July.

“So there’s a lot more stimulus to come,” says Mr Krugman, “and infrastructure is just a small part of the president’s overall recovery plan. Most of the package involves tax cuts and aid to state and local governments.” He expects that the effects of the stimulus package should be known by year’s end.

This is not to imply he is uncritical of the entire plan. First, he feels an extremely large portion of the plan was not really stimulus, but addressed problems with the Alternative Minimum Tax [which affects the more affluent] and tax cuts for middle-income families – moves not likely to spur significant additional spending.

“The real stimulus elements that make sense to me – infrastructure spending, aid to state and local governments, and temporary expansion of aid to social security recipients – were not an overwhelming majority of the bill,” Mr Krugman says.

But he believes that along with regenerating growth, the most important gain that could come from the package is correcting recent savage cuts in state and local government services involving education, healthcare, fire-prevention and infrastructure. “Slashing these services made no sense from any point of view,” says Mr Krugman.

He thinks past cuts in transport infrastructure and education have especially crimped potential GDP growth far into the future. Education spending is also on his win-win wish list: he suggests that preventing the firing of large numbers of teachers and making necessary school repairs would help sustain educational levels. It would also promote spending directly and indirectly through money spent by teachers and workers who would otherwise be laid off.

Another Krugman goal, expanding healthcare access, is desirable simply because it makes peoples’ lives a little less miserable while getting money into the economy, he says. At the same time, it frees up spending power of individuals and families whose resources would otherwise be swallowed up by these costs.

Paul Krugman is a professor

of Economics and International

Affairs at Princeton University

FT – Fund Management – Interview with Krugman <- Link to the Original News Article