SYNOPSIS: Paul Krugman tells us what to do to avoid a possible liquidity trap
Although other news has been drowned out by the barking of the dogs of war, something ominous is happening on the economic front. It's not dramatic, but month by month the numbers keep coming in worse than expected. Let's put politics completely aside for once, and review where we are and what should be done.
The key point is that this isn't your father's recession — it's your grandfather's recession. That is, it isn't your standard postwar recession, engineered by the Federal Reserve to fight inflation, and easily reversed when the Fed loosens the reins. It's a classic overinvestment slump, of a kind that was normal before World War II. And such slumps have always been hard to fight simply by cutting interest rates.
Now there's no question that the Fed's rapid rate reductions last year helped avert a much bigger slump. But a hard look at monetary policy suggests that the Fed hasn't done enough — and possibly can't do enough. Although the Fed funds rate, the usual measure of monetary policy, is at its lowest level in generations, the real Fed funds rate — the interest rate minus the inflation rate, which is what matters for investment decisions — is actually about the same as it was at the bottom of the last recession, in the early 1990's, because inflation is considerably lower.
And the drop in the Fed funds rate engineered by Alan Greenspan & Company, though faster than that in the last recession, has so far been considerably smaller; last time it fell by 6.75 points, this time it fell by only 4.75. Even if the Fed funds rate falls all the way to zero, that will be a smaller interest rate reduction than the last time around. If you think the excesses of the 1990's were larger than those of the 1980's, that the economy needs more stimulus to pull itself out, then it seems likely that the Fed hasn't done enough, and quite possible that even going all the way to zero still won't be enough.
And this situation may last for a while. The overhang of excess capacity, especially in telecommunications, will be worked off only slowly. It's all too possible that we may be looking at a sluggish economy into 2004, maybe beyond. The Fed should cut rates further — it may not be enough, but it will help. What else should we do?
The answer is that we should have a sensible plan for fiscal stimulus — one that encourages spending now, to bridge the gap until business investment revives. Some of the elements of such a plan are obvious, and were described by Jeff Madrick in yesterday's Times. First, extend unemployment benefits, which are considerably less generous now than in the last recession; this will do double duty, helping some of the neediest while putting money into the hands of people who are likely to spend it. Second, provide aid to the states, which are in increasingly desperate fiscal straits. This will also do double duty, preventing harsh cuts in public services, with medical care for the poor the most likely target, at the same time that it boosts demand.
If these elements don't add up to a large enough sum — I agree with Mr. Madrick that $100 billion over the next year is a good target — why not have another rebate, this time going to everyone who pays payroll taxes?
And how will we pay for all of this? You know the answer to that: Cancel tax cuts scheduled for the future. The economy needs stimulus now; it doesn't need tax cuts for the very affluent five years from now.
This isn't rocket science. It's straightforward textbook economics, applied to our actual situation. It's also, I'm well aware, politically out of the question. But I think we're entitled to ask why.
In a column on Sept. 17, I wrote about evidence that Thomas White, the secretary of the Army, was well aware that the Enron division of which he was vice chairman before taking that position, Enron Energy Services, was deliberately and improperly concealing large financial losses. In that column I cited a February 2001 e-mail message that I said was written by Mr. White. Since then Mr. White has said that he does not recall writing such a message, and the authenticity of the message has been questioned. As long as the authenticity of the message remains in doubt, it should be considered unsubstantiated. I erred by citing it in my column.
Originally published in The New York Times, 10.4.02