Economics: A voice in the wilderness

Paul Krugman on why economists misread the financial crisis and the U.S. still needs more stimulus.

Paul Krugman is renowned among economists for his thinking on trade and geography — work that earned him a Nobel Prize in 2008. But while his economics work has garnered him respect in his field, his other job — as an op-ed columnist for The New York Times — has earned the Princeton professor a reputation as one of the most influential public voices in America today. A self-described liberal, Krugman was a vocal critic of the Bush administration, but he has also spoken out against some of Barack Obama’s policies, particularly financial reform and fiscal stimulus (he thinks both are inadequate). The economist, 56, appeared recently at a Centre for International Governance Innovation conference in Waterloo, Ont., where he spoke with special projects editor Joe Chidley.

CB: Let’s talk about your profession and its role in the recent economic crisis. Do economists have a lot to answer for?
PK: Yeah. Now, first of all, 80% or 90% of economists are doing stuff that is blameless and has nothing to do with this. But in two fields — finance and macroeconomics — there was some really bad guidance given by large fractions of the economics profession. On the finance side, there was a lot of assurance that we really had the problems of risk management licked. On the macro side, while some people did see the kinds of risks that were facing us, a lot of people were assuring us also that we had this thing licked. And from the macro side, there has been incredibly divided counsel in terms of how we respond to this, which is also not helpful.

About 30 years ago, some economists decided that in a world of perfect markets and perfectly rational people, Keynesian-type recessions could not happen and therefore do not happen. So they went off into a world in which they decided to disbelieve all the things that had been learned over the previous 45 years about why, in fact, things go wrong. And that left them positively harmful in the crisis. Basically, they said that what just happened to us was not possible. But also they’ve made arguments — more or less incoherent arguments — against rescuing the world economy. The fact of the matter is that there was a faction in the economics profession that in this crisis was giving the same bad advice that Andrew Mellon gave Herbert Hoover, which was just to let it happen, don’t do anything.

CB: “Liquidate them all.”
PK: Yeah. And that’s a sad commentary on the profession, that we would be back to making those old mistakes after all these years. We forgot a lot of what our grandfathers learned through hard experience.

Just making a forecasting error — that’s always going to happen. Worse is having a model in which the kind of crisis that we’re having is impossible. But what’s really been destructive is that as we try to deal with it, we’ve had a lot of really bad counsel coming from a lot of high-prestige economists.

CB: Such as?
PK: Well, [Nobel Prize winners Robert] Lucas and [Edward] Prescott. This has been really not what we needed. And it’s showing. Part of the reason the rescue efforts, while helpful, have been undersized, and part of the reason we don’t have political consensus to do more even though the jobs picture in the U.S. remains grim, is that we’re getting this intellectual confusion from the economics profession.

CB: The U.S. still needs more stimulus?
PK: Yes. I know that at the moment there’s no way to get that through Congress, but we really do. We’ve stepped back from the edge of the abyss. The second Great Depression has been postponed, perhaps indefinitely. We’re at the trough in terms of GDP, though there might be another dip next year. But we’re still losing jobs. The unemployment rate has certainly not peaked, and probably won’t peak for quite some time to come. So it may be the bottom as far as output indicators are concerned, but it isn’t even the bottom as far as employment is concerned. A true return to anything that you could call full employment is lost in the mist of the future.

CB: So are you concerned about the long-term debt?
PK: I’m worried about the long-term debt. I’m not panicked about it. Experience suggests that advanced countries can go up to 100% of GDP in debt, or more, without having a collapse of confidence. Ordinarily, that would have given a great deal of comfort. But in fact, even on the [Obama] administration’s forecast, we’re going to have federal debt at 70% of GDP, plus another significant amount at the state and local level. So I’m not at ease about it, but I’m not panicked about it. Advanced countries do get a lot of running room on these things.

The main thing to say is that not supporting the economy saves you very little in terms of long-term debt levels. The actual fiscal burden of it is very much less than the headline number, partly because it expands the economy in the short term, and some of it comes back to [government] in the form of revenue.

So stimulus spending is actually quite cheap. We’re having huge deficits because we had an economic collapse. Trying to stimulate the economy doesn’t do much to add to those deficits, but does a lot to address the collapse.

CB: What about the other looming crisis in the U.S.: the so-called entitlement gap in social security and health care?
PK: Stimulus is neither here nor there in terms of that — a trillion here or a trillion there won’t make a difference in the size of that thing. The gap is primarily a health-care cost issue. The aging of the population, the demography, is significant, but would be manageable if that’s all there was to it — a few points of GDP, which is not easy but not a catastrophe. What makes it look like catastrophe is the excess cost growth in health care. And so you have to have health-care reform. Circa 2019, if we can have had serious health-care reform, policies currently on tap would probably still leave us with three or four points of GDP that we need to do something about — some higher taxes and maybe something that we need to cut in spending. Which is big, but not colossal. If we don’t get health-care reform, the whole thing is helpless.

CB: How is Barack Obama doing, and why is his popularity taking such a hit?
PK: I think the poli-sci people at Princeton, Larry Bartels in particular, have convinced me that it’s very mechanical: it’s the state of the economy. Almost nothing else matters. We’re losing jobs, so Obama’s lost a lot of popularity.

Now, on health care, as a political matter he has to get something through. That would be a big failure if he doesn’t. Right now, I think we are going to get health-care reform. It’s going to be deeply disappointing compared to what we really should be doing, but it will be vastly better than what we have now, and hopefully it will be fixable over the years.

CB: And the next big hurdle, you think, is climate change legislation?
PK: Well, it has to be done. Politically, it’s hard to rally people around it. But I think there is a growing quorum of people who understand that this must be done. And it happens to be revenue positive, which doesn’t hurt in the current environment.

CB: Really? Revenue positive?
PK: Yes, climate change is revenue positive [because carbon emission permits are auctioned off]. So that just makes it easier in terms of the process. You don’t have to ask, “How are we going to pay for this?” because it more than pays for itself. Beyond that, yeah, it’s very tough. A lot of people are going to be angry. But maybe we can actually do this.

CB: You’re a trade economist. Some have claimed free trade policy contributed to the economic crisis. Is that fair?
PK: I don’t think trade policy has had much to do with it one way or the other. The truth is, the story about the Great Depression — that Smoot-Hawley caused it — is actually not true. It’s all kind of a mythology, a kind of noble lie that’s been used to fight protectionism. I’m against protectionism, but that’s actually not a very good argument.

The only thing I think you can say is that free trade, globalization, meant that the crisis propagated a lot more strongly. It’s been really striking that countries that did not have a whole lot of financial excesses on their own, like Japan or Germany, got hit hard just through exports. As for financial globalization, you could certainly make a case that open capital markets helped set the stage. But what really made that possible in the first place was the fragility and the screwed-up nature of our own financial system. Trade and globalization are part of the backdrop to the crisis but not really part of the story.

CB: In Canada, of course, the Buy American provisions in the U.S. stimulus package were a political sore point.
PK: Yeah, sounds bad. But there was in fact not very much bite to them. Given how much we need stimulus, the argument that “people are going to take the money and spend it at Wal-mart and it all goes to China,” though it’s mostly wrong by the numbers, is a very potent one politically. So you do need to have some answer to that.

CB: Where’s America going to come out of this recession in terms of international standing? Are you concerned about China taking over as the world’s largest economy?
PK: Not because of the crisis. The fact of the matter is that China, unless they all poison themselves, will be the world’s largest ecoomy in the not too distant future, because there are a lot of Chinese and they’re as smart as we are. So they don’t have to be as productive; they only have to be a quarter as productive to become the world’s largest economy. [But] the crisis has not done much to shift the standing. One of the weird effects is, I actually think the international role of the dollar has ended up being reinforced. The only real credible rival was the euro, and the Europeans have had a fragmented response. So despite everything, the dollar has had its reign as the global key currency probably extended by the crisis.

What has happened, though, is that the moral authority of the United States on economic policy has taken a huge hit. For all these years, Americans have gone around the world telling everyone, “We know how to do things. We understand the secrets of economic success.” I don’t think people will want to listen to us much anymore.

CB: When you began writing op-eds for the Times nearly a decade ago, did you plan on becoming a political commentator?
PK: Not a bit. We shook hands on the thing in the summer of ’99, and at that point I thought I’d be writing about economic crises — but in other countries. I thought I’d be writing about crony capitalism and so on — in other countries. And politics, I thought, would be a relatively minor thing. But watching what was unfolding in the United States, there was no way I could say, “Well, I’m just going to write about the ups and downs of the stock market.”

CB: Do you think it’s helped or hurt your standing as an economist?
PK: God knows. There were, in fact, friends who said, “Why are you doing this? You’re throwing away your chance at a Nobel.” Which turns out not to have been true. So, what the hell?