The return of the depression economy


Author: Paul Krugman

Source: O Globo, 15/11/2008

In fact, we will probably not see an unemployment rate equal to the peak of 10,7% in the post-1982 depression (although, unfortunately, I cannot guarantee this).

We are, however, already well within the realm of what I call the "depression economy".

By this, I mean a state of affairs like that of the 30s, in which the usual instruments of economic policy - above all, the ability of the Federal Reserve (Fed, the American central bank) to stimulate the economy by cutting interest rates - have lost strength.

When the economy of depression prevails, common rules of economic policy lose their applicability: virtue turns into addiction, caution into risk and prudence into folly.

To understand what I'm saying, consider the implications of the latest bad news in the economy: the rise in claims for unemployment benefits, released on Thursday, which have passed the half a million mark. As terrible as it may seem, this data, seen in isolation, may not sound catastrophic.

After all, it is roughly the same number as the recessions in 2001 and 19901991-XNUMX, and both ended up being relatively mild. However, on these two occasions the standard reaction to the weakened economy - a Fed rate cut - still worked.

Today, no more: the rate is already very low. That is, there is not much left to be cut.

And, without the possibility of further reductions in interest rates, there is nothing that can contain the contraction of the economy.

The increase in unemployment will cause a reduction in consumer spending. This, in turn, will lead to cuts in companies' investment plans. And the weakening of the economy will cause more layoffs, fueling the contraction cycle.

To get out of this downward spiral, the federal government will have to provide economic stimulus in the form of more public spending and help for those affected by the crisis - and the stimulus package will not arrive in time or be strong enough, unless politicians and economists transcend various conventional prejudices.

One is the fear of red paint. In normal times it is good to be concerned about fiscal deficit - fiscal responsibility is a virtue that we will have to relearn after the crisis is over. But when the depression economy dominates, that virtue becomes an addiction.

Another prejudice is that government action must be cautious. In normal times it makes sense. But in the current situation, caution is a risk, because the changes for the worse are already occurring and any delay in reacting increases the chances of a greater economic disaster.

Finally, in normal terms, modesty and prudence in economic policy are good things. But today, it is better to make mistakes by doing more than doing less. The risk, if the stimulus package turns out to be excessive, is that the economy will overheat, fueling inflation - but then the Fed may raise interest rates.