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
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
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
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
AR I read Keynes'
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.