Is Bush destroying the Economy

Is Bush destroying the economy?

Paul Krugman on deflation

Something about Paul Krugman's writings terrifies the staid New York Times. They're supposed to be "the" liberal newspaper of record, but with only a handful of liberal columnists left, they keep digging a deeper hole to bury them in. Maybe it's just for this one weekend, but Paul Krugman's column, which had been moved from Sundays and Wednesdays to Tuesdays and Fridays, has been further de-relegated to the black hole of newspaper publishing: the Saturday edition.
A cynic would say that they just don't want Krugman's message getting out. Well, to hell with fair use, if you don't want to register at the New York Times to read the whole thing, here's a sizeable chunk of what the Times and the Bush administration don't want you to know about:

The particular type of quagmire to worry about has a name: liquidity trap. As the I.M.F. report explains, the most important reason to fear deflation is that it can push an economy into a liquidity trap, or deepen the distress of an economy already caught in the trap.

Here's how it works, in theory. Ordinarily, deflation — a general fall in the level of prices — is easy to fight. All the central bank (in our case, the Federal Reserve) has to do is print more money, and put it in the hands of banks. With more cash in hand, banks make more loans, interest rates fall, the economy perks up and the price level stops falling.

But what if the economy is in such a deep malaise that pushing interest rates all the way to zero isn't enough to get the economy back to full employment? Then you're in a liquidity trap: additional cash pumped into the economy — added liquidity — sits idle, because there's no point in lending money out if you don't receive any reward. And monetary policy loses its effectiveness.

Once an economy is caught in such a trap, it's likely to slide into deflation — and nasty things (what the I.M.F. report calls "adverse dynamics") begin to happen. Falling prices induce people to postpone their purchases in the expectation that prices will fall further, depressing demand today.

Also, deflation usually means falling incomes as well as falling prices. In a deflationary economy, a family that borrows money to buy a house may well find itself having to pay fixed mortgage payments out of a shrinking paycheck; a business that borrows to finance investment may well find itself having to pay a fixed interest bill out of a shrinking cash flow.

In other words, deflation discourages borrowing and spending, the very things a depressed economy needs to get going. And when an economy is in a liquidity trap, the authorities can't offset the depressing effects of deflation by cutting interest rates. So a vicious circle develops. Deflation leads to rising unemployment and falling capacity utilization, which puts more downward pressure on prices and wages, which accelerates deflation, which makes the economy even more depressed. The prospect of such a "deflationary spiral," rather than the mere prospect of deflation, is what scares the I.M.F. — and it should....

Our own situation is strikingly similar in some ways to that of Japan a decade ago. Like Japan circa 1993 or 1994, the United States is now facing the aftermath of a huge stock market bubble — the Nikkei and the Standard and Poors 500 both tripled in the five years before their respective peaks.

Also like Japan, we face a problem not of sharp downturn but of persistent underperformance — an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization.

What's different is that we have Japan as a cautionary example....

Once the U.S. economy began to falter, it cut rates early and often, trying to get ahead of the problem. Those cuts certainly helped moderate the slump; but at this point, with the overnight interest rate down to 1.25 percent, the Fed has almost run out of room to cut. (Fed officials believe, for technical reasons, that going below 0.75 would be counterproductive.) And the economy remains weak.

The Bush administration is, of course, notably unconcerned about deficits. Aren't the tax cuts in the pipeline exactly what the economy needs? Alas, no. Despite their huge size — if you ignore the gimmicks, the latest round will cost at least $800 billion over the next decade — they pump relatively little money into the economy now, when it needs it. Moreover, the tax cuts flow mainly to the very, very affluent — the people least likely to spend their windfall.

Meanwhile, state and local governments, which are not allowed to run deficits — we have our own version of the stability pact — are slashing spending and raising taxes. And both the spending cuts and the tax increases will fall mainly on the most vulnerable, people who cannot make up the difference by drawing on existing savings. The result is that the economic downdraft from state cutbacks (only slightly alleviated by the paltry aid contained in the new tax bill) will almost certainly be stronger than any boost from federal tax cuts....

Of course, it's possible, maybe even likely, that their nonchalance will be vindicated. Most analysts don't think we'll find ourselves caught in a liquidity trap. And even the Fed believes — or is that hopes? — that a surge in business investment will save the day.

But few analysts saw the Japanese quagmire coming either, and there is now a significant risk that we will find ourselves similarly trapped. Even so, we won't have deflation right away. But by the time we do, it will be very hard to reverse.

Like the Fed, I hope that doesn't happen. But hope is not a plan.
Today's Twin Cities Babelogue's Quote of the day is especially appropriate to this discussion:
"Corrupted by wealth & power, your government is like a restaurant with only one dish. They've got a set of Republican waiters on one side & a set of Democratic waiters on the other side. But no matter which set of waiters brings you the dish, the legislative grub is all prepared in the same Wall Street kitchen."

— Huey Long

Extra credit: reconcile all of the above with the Bush administration's push for a tax cut.
NOTE: I've just learned that Krugman's keeping his regular Tuesday-Friday rotation. Because of the length of this particular column, they held it until Saturday and ran it in its entirety.
Posted by Mark Gisleson


# -- Posted 5/24/03; 9:45:42 AM