The Great Recession

Krugman Today

Earlier this week, the Federal Reserve released the minutes of the most recent meeting of its open market committee - the group that sets interest rates. Most press reports focused either on the Fed's downgrade of the near-term outlook or on its adoption of a long-run 2 percent inflation target.

But my eye was caught by the following chilling passage (yes, things are so bad that the summarized musings of central bankers can keep you up at night): "All participants anticipated that unemployment would remain substantially above its longer-run sustainable rate at the end of 2011, even absent further economic shocks; a few indicated that more than five to six years would be needed for the economy to converge to a longer-run path characterized by sustainable rates of output growth and unemployment and by an appropriate rate of inflation."

So people at the Fed are troubled by the same question I've been obsessing on lately: What's supposed to end this slump? No doubt this, too, shall pass - but how, and when?

Read on. It isn't pretty.

Politics and the Economic Crisis

Barack Obama's historic election as a new, national agent of change will face a daunting test as the economic crisis continues to accelerate, and the political pressures arising from what must now be called “The Great Recession” begin to reshape the response.

The latest evidence is today’s unemployment data: one million jobs lost in two months; the sharpest eight-month rise in the jobless rate since 1945, when tens of millions of soldiers and sailors were demobilized; and losses across every sector and every region. Jobs are in freefall along with the markets, investment, consumer spending and household wealth. And economists are now genuinely frightened by the course the Great Recession is taking, because there’s been nothing like it in anyone’s experience.

That’s why long-time advocates of fiscal probity now call for stimulus topping $1 trillion, and why every spending and tax idea floating around Congress for the last decade is back on the table again. The political pressures and real concerns are so overwhelming that there’s talk of large tax cuts, despite the consensus among economists that when people and businesses are as economically downcast as they are today, tax relief has little stimulus power. That’s not only politics at work; it also reflects a sense of grave foreboding among many of those same economists.

We do need unprecedented stimulus – but all of the stimulus in the world won’t change the course of this crisis until we also address its underlying forces. The wealth of American households and the portfolios of American financial institutions will continue to tank until the housing market stabilizes -- or at least until foreclosure rates return to normal. And the most aggressive, easy policy in our history won’t be enough, and financial institutions won’t begin normal lending again, until they’re more confident that the hundreds of billions of dollars in mortgage-backed securities and other derivatives they still own aren’t headed for the drain as well.

The new Administration can take on these challenges directly, as candidate Obama pledged to do with extraordinary foresight. For example, we can impose a 90-day moratorium on foreclosures and use the time to renegotiate the terms of tens of thousands of distressed mortgages held by Fannie Mae and Freddie Mac. One idea promoted by many economists is to convert those mortgages to 30-year fixed at 5.25 percent, which happens to be long-term mean rate for Fannie and Freddie mortgages. It won’t stop foreclosures, but it should bring down foreclosure rates to near-normal levels, which would do more to stabilize the financial system than the bailouts in the Bush Administration’s own Wall Street version of tsunami stimulus. And some tough love from the new Treasury Secretary could help restart the lending process: having done what we can to stabilize the value of their portfolios, we should consider requiring institutions receiving federal aid to use a real share of that assistance to restart their lending.

We need large-scale stimulus, but it will only work if we first address the underlying problems. Otherwise, 18 months from now, we could be $1 trillion poorer and have little to show for it.

Christian Science Economics

The Bush administration, long known for faith-based initiatives, has embraced a new form of faith-based economics to address the financial crisis and cascading recession: We’ll call it an economic version of Christian Science, prescribing modest steps to make the patient comfortable while largely leaving us to heal ourselves.

It’s only an analogy, but play along. A succession of debilitating infections has left the American economy in critical condition. The specialists (the Treasury and Fed) have prescribed the application of salves (the bailouts) wherever the infections break through the skin (financial institutions facing bankruptcy), while the actual infections (rising home foreclosures, lax or absent regulation, and the credit freeze) are left to heal themselves. As the patient deteriorates, the family (Congress and the White House) faithfully hang on every word from the specialists; and like everything in modern medicine, the price tag is astronomical. Months into this regimen, the treatments have done little to control the infections, and the patient’s condition is critical.

The current regimen also leaves the economy vulnerable to new shocks to its system, and they’re almost certainly coming. Lucky for everybody, this patient can’t pass away – but the economy could require life support for another year and come out of this with long-term disabilities. This week’s shock came from Bernard Madoff and his accomplices. In normal times, the banks and other institutions that gave Madoff tens of billions of dollars to invest would write down the losses with modest effects on their other activities. Or, if the bailout regimen had included serious measures to stem the housing foreclosures still eroding the value of mortgage-backed securities, the institutions could better absorb the new Madoff losses. But more than half-year into this crisis, the Drs. Bush, Paulson, and Bernanke have still left hundreds of large banks and funds exposed to additional rounds of mortgage-backed-security losses, and thus all the more vulnerable to unexpected losses from sources like Madoff’s schemes. It’s not too late for Congress to address the underlying infection here, with a 90-day moratorium on foreclosures, and a commitment by Fannie Mae, Freddie Mac and the institutions collecting taxpayer bailout money to renegotiate the terms of the distressed mortgages they hold.

The Great Recession we’re all living through will inflict additional, damaging shocks on the economy. For example, the budget deficit is growing at a record pace, fueled by the accelerating decline and stimulus packages that include virtually every idea any member of Congress has considered over the last decade. The new catch is that as the effects of the economic decline spread to the countries which finance most of our deficits, especially China and Japan, the global pool of savings is contracting. On top of that, the recession has taken hold in much of Europe, driving up their deficits. The inevitable result will be intense competition next year for a shrinking global savings pool, which in turn will put upward pressure on our interest rates in the midst of deep recession. And that will further slow the resumption of normal lending – because, once again, the bailout regimen simply applied a salve of taxpayer infusions for financial institutions without addressing their dogged resistance to using those funds to resume normal lending.

The good news in all of this is that the nations that regularly make trouble for the U.S. – Russia, Iran, and Venezuela – all find themselves in terrible straits. The global recession has driven down their oil revenues (and the value of their government bonds) faster than an American 401K. Unfortunately, as Harvard’s Ricardo Hausmann points out, the global crisis also is cutting off foreign capital flows to most developing nations, including stable and friendly places such as Mexico, South Africa, Turkey, Brazil, and Malaysia. President Obama may well find Vladimir Putin and Hugo Chavez much weakened adversaries. But he and Secretary of State Clinton could well also face new problems triggered by economic upheavals in many parts of the developing world. The silver lining for us is that much of the capital that would have gone to developing countries will flow here instead, hopefully moderating the upward pressures on interest rates. In order to take advantage of it, however, Congress will have to go beyond the administration’s salves and attach explicit lending requirements to the next round of bailout funds.

The current regimen of Christian Science economics is working no better in this financial crisis than the medical version would work in a deadly epidemic. The American economy will not get well on its own. Fortunately, however, the architects of this approach will retire in a month, and the country then can turn to more able doctors.

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