The Liquidity Trap

Aaron, The Book Reporter, summarized Paul Krugman's book End This Depression Now in newbooksinbrief.wordpress.com. The article below summarizes Aaron's presentation.

According to Krugman, while America’s current situation is really quite dire, the reason the country finds itself in this situation is really rather simple. It all has to do with demand: “why is unemployment so high, and economic output so low? Because we—where by ‘we’ I mean consumers, businesses, and governments combined—aren’t spending enough… we are suffering from a severe overall lack of demand”. Actually, this whole scenario is unfolding as something of a domino effect, as is the case with all downturns. To be specific, consumers have stopped spending, which means that businesses do not feel the need to hire more employees and/or ramp up production; and since production is down, governments are earning less revenue through taxes, and are themselves more reluctant to spend.

So, how did we get into this? How does a country get itself out of this kind of slump?


The Root of the Problem: The Deregulation of the Financial Sector

The Political Influence of the Financial Sector (and the Wealthy in General)

The Solution is Government Stimulus (and a Few Other Reforms)

Objection #1: Government Stimulus Doesn’t Spur the Economy (and Response)

Exhibit A: The Great Depression

The Initial Stimulus Effort Was Too Small

Solution Specifics—Stimulus Specifics

Solution Specifics—Housing Relief (et. al.)

Objection #2: The Danger of Government Debt (and Response)

The Chances of Government Stimulus Being Implemented (and How to Improve Them)

Pragmatic Politics and the Coming Election
- An Obama Win, and a Divided legislative branch


Supply-side

Austerity


The Root of the Problem: The Deregulation of the Financial Sector

Now, a lot has been made of the issue of how Americans came to be so indebted in the first place, for this was a major part of why the current problem is so bad. Commentators on the right tend to blame borrowers who took out loans that they were not in a position to pay back, as well as government supported agencies who provided cheap loans to under-funded home-owners. Commentators on the left, on the other hand, tend to put the blame on deregulation in the financial industry, which allowed banking and investment companies to take on undue risk, as well as the banking and investment companies themselves who took advantage of the situation by way of providing loans to overly-risky borrowers. Krugman himself is primarily in the latter camp.

To begin with, Krugman claims that the vast majority of bad mortgage loans were made by private firms, not the much maligned government-sponsored Fannie Mae and Freddie Mac, who, the author contends, got into the bad mortgage game only very late, and not nearly to the extent that private companies did. But the root of the problem, according to Krugman, is the steady deregulation of the financial industry that began under Regan in the 1980’s, and that culminated with the Gramm-Leach-Bliley Act of 1999, which repealed a provision of the Glass-Steagall Act.

Glass-Steagall was a bill passed in 1933 to deal with the ongoing Great Depression. The major provision in the bill was that commercial banking deposits would be insured up to a certain point by the federal government. This was meant to restore confidence in banks, many of whom had fallen to bank runs in the previous years. The issue with insuring bank deposits, though, is that this creates a moral hazard for the banks. For the banks know that they will ultimately be bailed out by the government (meaning taxpayers) if they fall into insolvency; and, as such, they are tempted to make overly-risky investments. As Krugman explains, “it could have created a situation in which bankers could raise lots of money, no questions asked—hey, it’s all government insured—then put that money into high-risk, high stakes investments, figuring that it was heads they win, tails taxpayers lose”.

In order to protect against this moral hazard, the legislators behind Glass-Steagall also included a provision that stipulated that commercial banks could not act as investment banks. This was meant to keep commercial bank deposits safe from overly-risky investments. As Krugman notes, “any bank accepting deposits was restricted to the business of making loans; you couldn’t use depositors’ funds to speculate in stock markets or commodities, and in fact you couldn’t house such speculative activities under the same institutional roof”. In 1999, though, this provision of the Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act.

According to Krugman, this move was the height of irresponsibility, and was a major contributor to the extreme risk-taking environment that led directly to the financial crash of 2008.

Now, unlike some left-wing commentators, Krugman is not prepared to let consumers off the hook entirely for the debt problems that complicated the crash. Indeed, the author (following the economic thinker Hyman Minsky) argues that a big factor behind the growth of consumer debt in the recent past was a general natural tendency for people to forget about the dangers of debt during good times. As Krugman explains, “an economy with low debt tends to be an economy in which debt looks safe, an economy in which the memory of the bad things debt can do fades into the mists of history. Over time, the perception that debt is safe leads to more relaxed lending standards; businesses and families alike develop the habit of borrowing; and the overall level of leverage in the economy rises”. As the quote makes clear, the optimism in question touched all Americans, not just the lenders, and so all involved deserve some share of the responsibility.
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The Political Influence of the Financial Sector (and the Wealthy in General)

Over and above the factors mentioned above, though, Krugman argues that there is a still more sinister explanation behind the deregulation of the financial sector. And this has to do with the political influence of those who benefited most from it: the bankers themselves. Take the Gramm-Leach-Bliley Act of 1999, for instance (which, you will recall, revoked a crucial regulatory provision of the Glass-Steagall Act). As Krugman points out, the passing of the Act was largely influenced by the lobbying of Citicorp and Travelers Group, who in 1998 had wanted to amalgamate to become Citigroup, but who had encountered obstacles due to Glass-Steagall.

And even before this, the political elite stood in defense of increasing deregulation, despite initial indications that the measures were problematic. Indeed, as Krugman is wont to stress, the problems posed by deregulation did not begin with the financial crash of 2008. Instead, they began to surface even in the 1980’s when the banking sector was first deregulated. For instance, in 1989 the Federal government was forced to shut down the thrift banking industry due to a collapse induced by bad debt—a desperate move that put taxpayers on the hook for $130 billion. Then, in the 1990’s, further difficulties arose when several large commercial banks over-extended themselves “in lending to commercial real-estate developers”. Finally, “in 1998, with much of the emerging world in financial crisis, the failure of a single hedge fund, Long Term Capital Management, froze financial markets in much the same way that the failure of Lehman Brothers would freeze markets a decade later”.

For Krugman, all of these events should have acted as clear warning signs that there was something seriously wrong with financial deregulation. So why did the political elite fail to heed the warning signs? For Krugman, this becomes a good deal more understandable when we appreciate how profitable deregulation was for the financial sector, and how much influence this sector has on government. Indeed, as the author points out, while deregulation did virtually nothing to increase the incomes of middle class families, the move was a great boon to the wealthy, and especially the bankers themselves.

In addition, it’s no secret that the wealthy, and the financial sector in particular, has a major influence on government. This influence exists not only in the form of significant monetary contributions, but in the two-way cross-over between the financial sector and political office. What’s more, the influence of the wealthy has been increasing as the rich have gotten richer since the time when deregulation first took off.
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The Solution is Government Stimulus (and a Few Other Reforms)

Krugman certainly maintains that reforms in financial sector regulations are needed if the country is to avoid falling into future debacles such as it finds itself in presently. For him, though, the more important question has to do with how to get the country out of its current situation. As you will recall, Krugman contends that America’s problem now is that it is in the midst of a liquidity trap. That is, interest rates are already at zero, and yet this still isn’t enough to reignite consumer spending. What’s more, since consumers aren’t spending, businesses have no reason to hire workers and/or expand their operations, and so they aren’t spending either. And yet, for Krugman, this lack of spending is very much the heart of the problem. So what can be done?

According to Krugman, the answer is simple: the government must step in and take over the role of spending. As the author puts it, “the essential point is that what we need to get out of this current depression is another burst of government spending. Is it really that simple? Would it really be that easy? Basically, yes”. Krugman’s argument is that government spending will put money into the hands of the people, who will then be able to recover enough to resume spending themselves. As consumer spending increases, businesses will increase production and hire more workers, thus fully pulling the economy out of its current slump.
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Objection #1: Government Stimulus Doesn’t Spur the Economy (and Response)

Now, some argue that government spending doesn’t actually increase demand and spur the economy at all, since, they claim, all it really does is take resources from one sector of the economy and transfer them to another. The argument is well-rendered by Brian Riedl of the right wing thing tank the Heritage Foundation, who Krugman quotes in his book: “the grand Keynesian myth is that you can spend money and thereby increase demand. And it’s a myth because Congress does not have a vault of money to distribute in the economy. Every dollar Congress injects into the economy must first be taxed or borrowed out of the economy. You’re not creating new demand you’re just transferring it from one group of people to another”.

Now, for Krugman, this argument may hold true under normal circumstances, when banks are lending and companies are competing for resources. But in a depressed economy this is not the case. Rather, in such a situation banks are not lending because safe investments net very little profit, and risky investments are, well, too risky. So in a depressed economy, resources go unused by the private sector. This being the case, government spending does not displace private spending; rather, it does nothing but increase demand.
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Exhibit A: The Great Depression

But for Krugman, we needn’t rely on theoretical arguments to establish that this is so. For we have a very important historical precedent that we can draw from. And this is none other than the Great Depression. According to the author, while the Great Depression may have been far worse than the current situation, the two scenarios are actually very similar in nature. Two points of similarity are particularly important here. To begin with, both slumps followed financial crashes. This is significant because, as Krugman points out, history shows that these types of slumps tend to be deep and prolonged.

Second, and even more significant, is that both situations were and are characterized by a shortage of demand, caused by a high level of consumer indebtedness. Indeed, as the author explains, “the real story behind the Great Depression [was] that the U.S. economy came into a recession with an unprecedented level of debt that made it vulnerable to a self-reinforcing downward spiral… And as I’ve already said… a similar if less extreme story is the main explanation of the depression we’re in”. Now, as Krugman notes, in the case of the Great Depression, the one and only thing that finally resolved the shortage of demand was when the government ramped up spending in preparation for the Second World War: “as military spending created jobs and family incomes rose, consumer spending also picked up… As businesses saw their sales growing, they responded by ramping up spending. And just like that, the Depression was over, and all those ‘unadaptable and untrained’, workers were back on the job”. And for Krugman, this is exactly the kind of approach we need right now.
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The Initial Stimulus Effort Was Too Small

Of course, those opposed to the stimulus approach will point out that the American government has already tried this strategy during the current slump. This came in the form of President Obama’s $787 billion American Recovery and Reinvestment Act. The fact that this stimulus package was not enough to rescue the American economy from its current slump, these opponents argue, demonstrates that the approach itself is ineffective.

For Krugman, though, the only thing that the ultimate failure of the American Recovery and Reinvestment Act demonstrates is that this stimulus package simply wasn’t big enough to do the trick. In essence, the author argues, America is currently in exactly the same situation as it found itself in during the 1930’s. At that time, the Roosevelt administration had initiated the job creation programs contained in the New Deal. The government spending under the New Deal was relatively large in scope; but, according to Krugman, persistent concerns regarding government over-spending kept the package from being as large as it needed to be: “all through the Depression influential voices warned about the dangers of excessive government spending, and as a result the job-creation programs of the New Deal were always far too small, given the depth of the slump”. When the war hit, though, these concerns were overridden by the larger concern of winning the war, and it was the subsequent increase in spending (meant to furnish the war effort) that ultimately drew the country out of the Great Depression. According to Krugman, this demonstrates that the concerns over government over-spending in the 1930’s were misguided (as they are today), and that that the real key to ending a depression is aggressive government stimulus.

Of course, Krugman’s argument that the latest stimulate effort was too small is based on more than just a certain historical parallel with the New Deal of the 1930’s. Indeed, the author argues that we could tell even before the American Recovery and Reinvestment Act was released that the package would be too small. This proves to be the case because the American economy is simply far too big, and the current slump simply far too deep, for $787 billion to have truly turned things around. As Krugman puts it, “a realistic assessment was that the stimulus would have to deal with three or more years of severe economic pain. And the U.S. economy is really, really big, producing close to $15 trillion worth of goods and services every year. Think about that: if the U.S. economy was going to experience a three-year crisis, the stimulus was trying to rescue a $45 trillion economy—the value of output over three years—with a $787 billion plan, amounting to well under 2 percent of the economy’s total spending over that period. Suddenly $787 billion doesn’t seem like that much, does it?”.
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Solution Specifics—Stimulus Specifics

So, just how much would be enough? Krugman never does put an exact figure on it, and this would seem to be because there is simply no way that we can know for sure. But, for the author, this does not mean that we don’t know where to begin. One of the key arguments for limiting the size of stimulus is that there are only so many projects that can be undertaken with which to spend it on at any one time. Krugman certainly agrees with this, but, for him, there are many good candidates on the table that could use the funding right now.

To begin with, shortages of government revenue at the state and municipal levels have forced these governments both to forestall new hires, and to lay off existing workers in the recent past. As Krugman notes, since the beginning of the recession in 2008, “the number of workers in those governments is down by more than half a million, with the majority of job losses coming from the area of education”. What’s more, if these governments had continued hiring on their previous course, they would now be employing roughly 1.3 million more workers than they currently are. According to the author, the money that would have gone to these workers—as well as other budgetary cuts that these governments have been forced to make—amounts to roughly $300 billion per year. Accordingly, Krugman claims that “right there is a stimulus of $300 billion per year that could be accomplished simply by providing enough aid to states and localities to let them reverse their recent budget cuts. It would create well over a million jobs directly and probably something like three million once you take the indirect effects into account”.

In addition to the aid extended directly to state and municipal governments, Krugman insists that there are also several infrastructure programs that could use the funding immediately. As the author points out, “they don’t have to be visionary projects like high-speed rail; they can be mainly prosaic investments in roads, rail upgrades, water systems, and so on”.

Finally, Krugman argues that a great deal more money could be extended to emergency aid programs that are helping Americans through the difficult times: “one more channel through which government could provide a fairly quick boost to the economy: more aid to distressed individuals, by means of a temporary increase in the generosity of unemployment insurance and other safety net programs. There was some of this in the original stimulus,” Krugman adds, “but not enough, and it faded out far too fast”.
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Solution Specifics—Housing Relief (et. al.)

Another measure that Krugman advocates is mortgage debt relief. For the author, a major part of the problem that America currently finds itself in is that a large number of citizens still face debilitating mortgage debt. Now, over the past few years, mortgage interest rates have dropped precipitously due to the depressed economy. In normal circumstances, homeowners would have been able to take advantage of this drop in interest rates by way of refinancing their homes, thus “reducing their interest payments and freeing up funds that could be spent on other things, boosting the economy”. However, because these same homeowners have lost so much equity in their homes, and because banks generally require a certain amount of equity in order to refinance, the banks have not been willing to allow this refinancing to occur.

For Krugman, then, “the solution would seem to be obvious: find a way to waive or at least soften these rules”. Now, as the author notes, the government has indeed set up a program with this goal in mind, called the Home Affordable Refinance Program (HARP). For Krugman, though, the program has not been near accommodating enough: “like previous housing policies, HARP has been far too cautious and restrictive. What is needed is a program of mass refinancing—something that should be easier because many mortgages are owed to Fannie and Freddie, which are now fully nationalized”.

In addition to the solutions mentioned above, Krugman adds two more: get tough on China, and beef up environmental regulations. As the author argues, “it’s long past time to take a tougher line on China and other currency manipulators, and sanction them if necessary. Even environmental regulation could play a positive role: by announcing targets for much-needed curbs on particulate emissions and greenhouse gases, with the rules to phase in gradually over time, the government could provide an incentive for businesses to spend on environmental upgrades now, helping accelerate economic recovery”.
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Objection #2: The Danger of Government Debt (and Response)

Now, as the reader will have noticed, many of the measures mentioned above would not come cheap. That is, the government would have to print more money, and go further into debt in order to carry them out. This makes many people uncomfortable, for government debt is in itself a problematic issue, and the printing of more money threatens inflation, and even hyperinflation, which can completely unhinge an economy. For Krugman, though, both of these concerns can be answered.

. . . Even more important than this, though, for Krugman, is that the government’s failing to spend now (and thus taking on more debt in the short term) actually threatens to increase the country’s debt burden in the long term. This proves to be the case because the longer the government resists spending, the longer the country will remain in a slump, and the longer the government’s revenues will suffer, which hurts its ability to pay down the debt. Accordingly, the author writes that “even if slashing spending reduces future debt, it may also reduce future income, so that the ability to bear the debt we have—as measured, say, by the ratio of debt to GDP—may actually fall”.

For Krugman, then, increased government spending at this time does not pose a threat in terms of sending debt out of control in America, and we should make this choice in terms of minimizing the debt burden going into the future.
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The Chances of Government Stimulus Being Implemented (and How to Improve Them)

Pragmatic Politics and the Coming Election
- An Obama Win, and a Divided legislative branch

In the event that Obama wins but faces opposition from at least one House, the trick becomes difficult. For the Republican Party has shown that they are prepared to block stimulus efforts. Now, as Krugman notes, early in Obama’s first term this Republican opposition kept him from harping on jobs as much as he might have otherwise; for Obama’s aides warned him “never to ask for things he might not get, on the grounds that it might make him look weak”. More recently, though, Obama has parted with this advice and has renewed calls for job-creation; and, as the author points out, these calls have gone over quite well with the American public. This development has put pressure on the Republican Party to relent on their anti-stimulus stance, and this has in fact had some tangible effects. Indeed, as Krugman notes, Obama put forth a job-centered proposal in September 2011, and, because of the current political landscape, “the Obama administration was able to get a significant fraction of what it wanted—an extension of the payroll tax credit, which helps put cash in workers’ pockets, and a shorter extension of extended unemployment benefits—without making any major concessions”.

According to Krugman this demonstrates that simply keeping the jobs-creation rhetoric high can pay significant dividends, and we prefer it to accepting the belief that the political right, and Americans in general, will not tolerate more stimulus efforts. In Krugman’s own words, “not talking about jobs simply because you don’t think you can pass job-creation legislation doesn’t work even as a political strategy. On the other hand, hammering on the need for job creation can be good politics, and it can put enough pressure on the other side to bring about better policy too”.
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Supply-side

Economic stimulus spending is known as demand-side economics. The opposing theory is called supply-side. The flaws of supply-side, or trickle-down economics were laid out last month on the Daily Kos. While the rich have gotten richer, everyone else has stalled or gone downhill. Krugman's disagreement with supply-side economics was carried sixteen years ago on slate.com:

The supply-side idea says that tax cuts have such a positive effect on the economy that one need not worry about paying for them with spending cuts. The extraordinary recent record of the supply-siders as economic forecasters: In 1993, after the Clinton administration had pushed through an increase in taxes on upper-income families, the very same people who have persuaded Dole to run on a tax-cut platform were very sure about what would happen. Newt Gingrich confidently predicted a severe recession. The Wall Street Journal editorial page had no doubts that the tax increase would sharply increase the deficit instead of reducing it. Well here we are, three years later: The economy has created 10 million new jobs, the market is up by 1500 points, and the deficit has been cut in half. The supply-siders were absolutely sure that his policies would produce disaster. Indeed, if their doctrine had any truth to it, they would have.

A handful of wealthy cranks can support an impressive-looking array of think tanks, research institutes, foundations, and so on devoted to promoting an economic doctrine they like. A few key funders, like the Coors and Olin Foundations, played a role in building an intellectual facade for late 20th-century conservatism. The supply-siders will always have a safe haven in the world of the Free Enterprise Institute and the Center for the Study of Capitalism, outlets for their views in the pages of Forbes and the Wall Street Journal.
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Austerity

Some Republicans and Libertarians favor the austerity solution. Drastically cut taxes and spending. Shrink government to a size small enough to drown it in a bath tub. Our government encounters political resistance to levying taxes large enough to carry out its functions or to fund a stimulus package. Greece, anyone?
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