Nobel Prize Winner Paul Krugman warns that the second Great Depression will be difficult to stop

In an Op Ed article in the NYT dated January 5, Paul Krugman writes that for many years, the predominant view has been that it would be quite easy to prevent another Great Depression. For example, Robert Lucas of the University of Chicago declared in 2003 that the "central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades." Milton Friedman persuaded many economists, including Ben Bernanke, the Federal Reserve chairman, that the 1929 Depression could have been stopped simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply.

Krugman says that the present financial and economic crisis shows that preventing depressions isn't so easy after all. "Under Mr. Bernanke's leadership, the Fed has been supplying liquidity like an engine crew trying to put out a five-alarm fire, and the money supply has been rising rapidly. Yet credit remains scarce, and the economy is still in free fall."

Milton Friedman's assertion that the Great Depression could have been controlled through monetary policy was an attempt to refute John Maynard Keynes, who had explained that monetary policy was ineffective during a depression. Fiscal policy, entailing large scale public spending by the government, was needed to fight mass unemployment.

Says Krugman, "The failure of monetary policy in the current crisis shows that Keynes had it right the first time. And Keynesian thinking lies behind Mr. Obama's plans to rescue the economy." The Economist confirms this in an editorial dated January 8: "With interest rates close to zero, the Federal Reserve is out of conventional monetary ammunition, so fiscal policy must do the lion’s share." In effect, Barack Obama’s economic package, if passed expeditiously by Congress, would create a surge in public spending in areas of high priority, provide employment to Americans who would otherwise be on relief, utilize idle money, and put labor and capital to work producing something of added value.

Krugman fears, however, that President-elect Barack Obama’s ambitious rescue plans may be difficult to implement in the face of Republican opposition which is determined to set up road blocks under the guise of "careful Congressional deliberation". On ideological grounds Republicans are opposed to an F.D.R.-type solution with heavy public spending. Many politicians demand proof "that the benefits of the proposed public spending justify its costs — a burden of proof never imposed on proposals for tax cuts".

As recent events have shown, the government has dished out tens of billions to banks and some other financial institutions without batting an eyelid. Keynes knew that giving money away tends to be met with fewer objections than plans for public investment "which, because they are not wholly wasteful, tend to be judged on strict 'business' principles."

Krugman is thus deeply concerned about the prospects for the Obama plan to rescue the economy. He is sure that Congress will pass a stimulus plan, but it may be delayed inordinately, downsized or both. As a result, the economy will plunge for most of 2009, and when the plan takes effect, it will only slow the dive, not stop it. Meanwhile, deflation will get entrenched leading to a permanently depressed economy. It could well presage the start of the second Great Depression, unless the leaders get their act together and pass the stimulus package expeditiously, albeit with due diligence and oversight.

After this the country will face the more difficult task of fiscal reform aimed at restoring a reasonable balance between spending and revenues, over time. According to the Economist, the Congressional Budget Office has calculated that America’s publicly held debt could rise from 41% of GDP in 2008 to 54% in 2010, a 55-year high, even without Mr Obama’s stimulus plans. Without major tax and spending reforms it could go up to a dizzying 400% by 2050. This is highly undesirable if not unacceptable and therefore represents a major policy challenge to the new administration.