SYNOPSIS: In a very comprehensive article Krugman explains the grim economic scene and how to improve it

It looks as if the authors of "Dow 36,000" — remember that? — may have had one digit too many in their title. Let's just hope it was an extra "3," not an extra "0."

The bull market is now well and truly over. In fact, if you adjust for inflation the S.&P. 500 — a much better measure than the overused Dow — is now below its level in late 1996, when Alan Greenspan gave his famous "irrational exuberance" speech.

So what should the responsible officials — Mr. Greenspan, George W. Bush and whatshisname, the Treasury secretary — be doing?

A good first step would be to stop trying to talk up the market by extolling the economy's fundamental strength. For one thing, it reeks of desperation. For another, stocks are still richly valued compared with earnings. Most important, the fundamentals aren't actually all that great. Doubts about corporate governance are growing, not fading away. State and local governments are in a desperate fiscal crisis. And even before the sudden plunge in the markets, the data were pointing not to a boom but to a "jobless recovery," in which the economy grows too slowly to make much if any dent in the unemployment rate.

Indeed, the report prepared in support of Mr. Greenspan's recent testimony projected no significant decline in unemployment this year, and not much decline next year. And in the face of plunging markets we have to worry whether even that forecast is overly optimistic.

Given the definitely iffy economic outlook, shouldn't Mr. Greenspan be thinking seriously about another interest rate cut? True, rates are already very low. But if there's one thing we've learned from Japan's experience, it is that when you face the risk of a deflationary trap — still not the most likely scenario, but not as unlikely as it seemed a few months ago — it makes no sense to "save your ammunition," holding interest rate cuts in reserve. The time to fight deflation is before it has time to get built into the nation's psychology.

True, the Fed has been concerned that another cut would panic the markets. But now that the markets have panicked on their own, there's nothing to lose.

What about the rest of the government? Corporate reform is essential; if investors cannot be reassured that they are being treated fairly, they will take their money and go home. But we can't count on reform to provide an immediate boost to the economy; trust, once lost, cannot be restored in a moment. What else can the government do?

Let's ignore the politics and look at the situation objectively. On one side, thanks in part to the end of the bull market the long-run federal budget outlook has worsened to an extent that has surpassed the expectations of even the biggest pessimists (like yours truly). Realistically, we are looking at a decade of deficits, which will eventually pose serious problems for Social Security and Medicare.

On the other hand, with the recovery still wobbly, this is no time for fiscal austerity — if anything, right now the federal government ought to be pumping more money into the economy than it is.

The obvious answer to this seeming dilemma is to loosen the reins now, but prepare to tighten them once the economy has fully recovered. For example, the Bush administration could move quickly to aid distressed state governments, avoiding harsh (and contractionary) cuts in essential programs. Meanwhile, to assuage worries about the long-run fiscal position, it could put on hold future tax cuts that were written into law back when visions of surplus sugarplums were still dancing in our heads.

And after the administration takes these responsible steps, thousands of pigs will fill the skies over Washington.

Look at it this way: The Bush administration's economic plans have not changed significantly since the fall of 1999, when they were introduced as a way to ward off a challenge from Steve Forbes. Back when the tax cut that eventually became law was announced, "Dow 36,000" was climbing the best-seller lists. The economic environment has changed completely; the administration's plans haven't changed a bit.

Our economic problems are real, but by no means catastrophic. What scares me is the utter inflexibility of the people who should be solving those problems.

Originally published in The New York Times, 7.23.02