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by Michael Zielenziger, AARP Bulletin, - December 22, 2008
Impish, informal and unabashedly liberal, Paul Krugman has long been intrigued by the unique challenges of restarting an economy in free fall—long before the credit crisis of 2008 plunged the United States into a severe recession and made his intellectual quest even more relevant. Krugman, 55, a professor of economics and public policy at Princeton University, a regular op-ed columnist for the New York Times and the author of numerous books, was awarded the Nobel Memorial Prize in Economics earlier this month for his groundbreaking research into the composition of international trade and economic geography. He’s never won a Pulitzer Prize for his commentary but says his Nobel is more satisfying because academic economists are “more my kind of people,” even if most of his books avoid complicated models and equations in favor of commonsense language everyone can understand.
Krugman’s latest book, The Return of Depression Economics and the Crisis of 2008, a substantial revision of a 1999 volume, describes how the rise of the housing bubble and a shadow banking industry of lightly regulated hedge funds and private equity groups helped contribute to the equity meltdown of the past year. Krugman also examines Japan’s “lost decade” of deflation amid Asia’s meltdown of the 1990s, when Japan took unprecedented steps to lower benchmark rates to nearly zero—just as the Federal Reserve recently did a day after Krugman spoke with AARP Bulletin Today.
Q. We’re seeing banks bailed out by the U.S. Treasury talk of a massive stimulus by government to jump-start the economy and the Federal Reserve Bank driving down interest rates to nearly zero. Is America beginning to resemble Japan after the collapse of its bubble economy?
A. Well, in many ways the current situation does resemble Japan because we are at the limits of conventional monetary policy, and yet the economy is still plunging.
Like Japan in the 1990s, we are in a situation where the standard tool for fighting recessions—which is having the Federal Reserve Bank reduce interest rates—has completely run out of room, and it isn’t nearly enough. And you can’t go lower than zero because people would hold cash instead of buying government bonds. So we are in a situation very much like that of Japan, called a “liquidity trap,” where the Fed’s normal tools have lost all traction.
Now maybe what we learned from Japan gets us out. Maybe the fact that Ben Bernanke, the head of the Federal Reserve, came into this knowing all about Japan’s problems and determined to do whatever he could to avoid them means we will spend less time in this trap than the Japanese did. But it’s not clear.
Q. Is this simply a panic or something more real?
A. What we’re seeing right now—kind of across the board—is a loss of confidence in the system. Unfortunately, it’s a loss of confidence that is capable of bringing the world economy to its knees. We cannot play games with this. If we did not have some understanding, if we had not learned some lessons from the Great Depression, I believe the shocks we are going through now would indeed produce a second Great Depression.
Q. Given all the government funds being provided, why are credit markets stuck?
A. The credit markets are stuck because people got overoptimistic, because they believed that bad things no longer happened. As a result, a lot of key players were able to operate with vast amounts of borrowed money and very little of their own funds at risk. And then things started to go bad.
This meant, first of all, the capital of a lot of financial firms was depleted. It meant confidence in the financial system went away, and so we have a great shortage of ability to lend or a willingness to lend, and anything that isn’t absolutely safe is frozen. Even very solid corporations are having a hard time raising money. What we’re left with is that every investor wants government debt, figuring that is the last safe asset on earth. And it’s not a good scene. It makes it very hard to keep the economy going.
Q. So what do you recommend?
A. The main thing is we are now in the [John Maynard] Keynesian world. We are in a world where large-scale creation of demand by the government is the best thing we can do to get this economy moving again. So we’re talking about public works spending, we’re talking about things that produce useful stuff that will last for the long term. But equally important will be to get people employed, get incomes rising and get the economy functioning.
Q. How much should the next president spend?
A. Realistic estimates, just taking perfectly ordinary consensus assessments of where the economy is going, suggest really huge sums, something around $600 billion in 2009 to keep the economy from being worse than it is now. That’s one helluva program. Though we like to say that politicians like to spend money, the need for a lot of spending quickly—spending that will be effective in boosting demand, not just socked away in people’s bank accounts—means that actually finding enough spending that we can do is going to be a real problem.
Q. Wait a minute. You’re saying government has a hard time spending money?
A. People tend to say cynically, oh, those guys in Washington don’t have any problem spending money. Actually, in this case they do. The search for reasonable projects that can be brought online quickly—shovel-ready projects, as they now are calling them—is really hard. There’s nothing like $600 billion of that. This is a unique problem.
When you are in this trap, you are in an Alice in Wonderland world where things are stood on their head, normal preconceptions are stood on their head, and the difficulty of finding enough stuff for the government to spend its money on, even though for the time being deficits are no object, becomes a really big policy problem.
Q. What about the argument that troubled companies like the Big Three automakers are responsible for their plight and should fend for themselves?
A. This is a big area of dispute. A lot of our normal instinct is to say that we have to let things fail, we shouldn’t keep the economy on life support. But if you studied the 1930s or studied Japan in the 1990s, you say that when you’re in this kind of trap the normal rules have to be waived, at least for a while. The problem in the economy is that there isn’t enough being spent, and you have to support spending to get you through this. Otherwise you risk going through a repeat of the Great Depression.
Q. Why is deflation, a world of falling prices, such a worry?
A. If prices are falling, no one wants to make a purchase now. If you are thinking about borrowing but know you will have to repay those dollars at a time when a dollar is worth more than it is today, that’s a big discouragement to borrowing and to spending. Expectations of deflation can really be corrosive because they can feed on themselves. If prices are falling, they can make the economy depressed, which causes prices to fall more, and you can get into a really very deep trap. It happened to the Japanese for much of the 1990s, and it’s what happened here in the 1930s.
That’s the reason to be really aggressive with policy now. If we do this with half measures—do a little bit and wait to see whether we need more—by the time we finally make the policy measures as big as they should have been, we’ll have a situation with deflationary expectations baked into the economy, and they get very, very hard to end.
So the lesson to be learned from deflation is, hit the thing hard with a lot of policy measures as quickly as we can. Hit it hard, hit it early and have the courage to keep going until you have an economic recovery.
Q. Many people have seen their 401(k)s shrivel to “201(k)s.” What is your advice to a 55-year-old trying to plan for retirement, or a 70-year old who has already seen a shocking decline in the value of retirement savings?
A. I can’t offer any promises. We don’t have a real answer. Stocks were arguably overvalued; there was excessive optimism. But one thing you can say is that right now the prices of assets all through the economy are factoring in a pretty high chance of major disaster. So if we have policies that steer us away from that major disaster and do produce an economic recovery, that’s the best thing we can do for everybody’s 401(k).
Q. So investors should just grit their teeth?
A. Well, I would have advised a couple years ago not to put too much of your money into stocks, but that’s water under the bridge, and I think at this point you just have to hope, you have to continue to save, you have to continue to have a balanced portfolio. Don’t try to second-guess the market, and hope that an economic recovery program makes assets across the board look more attractive again and unlocks those credit markets.
Q. Can I ask how you did in the recent slide?
A. I’m holding zero stocks.
A. We were entirely into cash and selective real estate, although very much specific things that we knew something about. Even so, we’ve taken a loss on the real estate, but we had no stocks at this point.
Q. What’s your sense of the real estate market?
A. Southern California’s real estate bubble of the late 1980s took about six years until prices hit bottom. This time prices have fallen faster, but I still think we’re probably not going to see a significant rise in home prices for several years out from here. Even now, home prices look substantially above historical norms compared to stuff like rents and incomes. So don’t count on home prices moving up any time soon.
Q. So you’d call yourself gloomily realistic?
A. Well, I guess so, yeah. I was gloomily worried before it was fashionable, but things have turned out even worse than I had imagined.
Q. And we all said that something like this would never happen again.
A. Well, I didn’t.
Q. Yet you think we have now learned enough to avoid a Great Depression.
A. I hope so. Most of the time I think we have, but some mornings I look at the latest economic news and I have my doubts.
Michael Zielenziger is a former Tokyo-based foreign correspondent and author of Shutting Out the Sun: How Japan Created Its Own Lost Generation.
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