What to Do

By Paul Krugman
The New York Review of Books, December 18, 2008

Edited by Andy Ross

The global credit system is paralyzed and a global slump is building momentum. Reform of the weaknesses that made this crisis possible can wait. First, we need to deal with the clear and present danger. Policymakers around the world need to get credit flowing again and prop up spending.

Behind the credit squeeze is the combination of reduced trust in and decimated capital at financial institutions. People and institutions don't want to deal with anyone unless they have substantial capital to back up their promises, yet the crisis has depleted capital across the board.

The obvious solution is to put in more capital. In 1933 the Roosevelt administration used the Reconstruction Finance Corporation to recapitalize banks by buying preferred stock. The provision of capital helped restore the ability of banks to lend, and unfroze the credit markets. A financial rescue along similar lines is now underway in the United States and other advanced economies.

This may not be enough. First, even if the full $700 billion is used for recapitalization, it will still be small relative to GDP. Second, it's still not clear how much of the bailout will reach the shadow banking system at the core of the problem. Third, it's not clear whether banks will be willing to lend out the funds.

My guess is that the recapitalization will eventually have to get bigger and broader, and that there will eventually have to be more assertion of government control. Nothing could be worse than failing to do what's necessary out of fear that acting to save the financial system is somehow "socialist." The same goes for getting the Federal Reserve to lend directly to the nonfinancial sector.

All these actions should be coordinated with other advanced countries. The reason is the globalization of finance. Part of the payoff for US rescues of the financial system is that they help loosen up access to credit in Europe, and part of the payoff to European rescue efforts is that they loosen up credit here.

A global rescue for developing countries is part of the solution to the crisis. During the autumn, the International Monetary Fund was providing loans to countries with troubled economies like Ukraine. Meanwhile, the Fed provided swap lines to several emerging-market central banks, giving them the right to borrow dollars as needed.

Even if the rescue of the financial system starts to bring credit markets back to life, we'll still face a global slump. What should be done about that? The answer is good old Keynesian fiscal stimulus. Once the recovery effort is well underway, it will be time to reform the system so that the crisis doesn't happen again.

In the aftermath of the Great Depression, we redesigned the machine to avoid big disasters. Banks were placed under tight regulation and supported by a strong safety net. Meanwhile, international movements of capital were also limited. The financial system became much safer.

Then growing international capital flows set the stage for devastating currency crises in the 1990s and for a globalized financial crisis in 2008. The growth of the shadow banking system, without regulation, set the stage for latter-day bank runs on a massive scale.

We need to relearn the lessons of the Great Depression. Anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated. Since the 1930s commercial banks have been required to have adequate capital. Now that non-bank institutions have created a banking crisis, regulation has to be extended to them.

I believe that John Maynard Keynes the economist who made sense of the Great Depression is now more relevant than ever. Keynes concluded his masterwork, The General Theory of Employment, Interest and Money, with a famous disquisition on the importance of economic ideas: "Soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

Paul Krugman is a columnist for The New York Times and Professor of Economics and International Affairs at Princeton. He was awarded the 2008 Nobel Prize in Economics.

AR  I read Keynes' General Theory in 1971. It was a definitive analysis of how to avoid economic depressions and a masterful treatment of the money system. Government spending and public works (and jobs) are the way out of depressions. As for money, it's the liquidity in a circulating system, like blood in a body, and needs to be pumped, essentially by work based on trust in its tradability.