Escaping the financial crisis

Deregulation of financial services was supposed to have made us all better off, so why did most of us have to live off credit to keep up? Now that it has all gone wrong, and everyone agrees we're in the worst crisis since the Great Depression, why aren't we following the lessons we learned in the 1930s?

President Obama is the only world leader who has attempted a Keynesian stimulus programme. Why has it been only minimally effective? Why do most other western leaders still insist the only way out is to tighten our belts and pay off our debts, when that clearly isn't working either? And how come the bankers, credit agencies and bond traders are still treated with cowed reverence – don't frighten the markets! – when they got us into this mess?
These mysteries were beginning to make me feel as if I must be going mad – but since reading Paul Krugman's new book, I fear I'm in danger instead of becoming a bore. It's the sort of book you wish were compulsory reading, and want to quote to anyone who'll listen, because End This Depression Now! provides a comprehensive narrative of how we have ended up doing the opposite of what logic and history tell us we must do to get out of this crisis.

Its author is a Nobel prize-winning economist who writes a column in the New York Times and teaches economics at Princeton University. An authority on John Maynard Keynes, Krugman wrote a book in 1999 called The Return of Depression Economics, largely about the Japanese slump, which drew ominous parallels between Japan's economic strategy and the pre-New Deal policies of the early 30s that turned a recession into catastrophic depression. At the time, unsurprisingly, most western economists weren't bowled over; in thrall to the seemingly endless boom, the Great Depression looked to them to be more or less irrelevant. Krugman's latest book will be much harder to ignore.

He doesn't expect it will be an easy message to sell, though. "As far as I can make out, the serious opposition to the coalition's policy is basically a half-dozen economists, and it looks as if I'm one of them – which is really weird," he laughs, "since I'm not even here." Visiting London last week, he met lots of what he calls Very Serious People: "And there are lots of things these people say that sound very wise and sensible. But it's all upside-down; it's all wrong. Yet the power of their orthodoxy – even when it's failing – is quite awesome."

These Very Serious People present economics as a morality play, in which debt is a sin, and we have all sinned, so now we must all pay the price by tightening our belts together. They tell us the crisis will take a long time to resolve, and must inevitably be painful. All of this, according to Krugman, is the opposite of the truth. Austerity is a self-imposed collective punishment that is not just unnecessary, but won't work. We know what would work – but for complex political and historical reasons that his book explores, we have chosen to forget. "Ending this depression," he writes, "should be, could be, almost incredibly easy. So why aren't we doing it?"

Krugman offers the example of a babysitting co-op, or circle, in which parents are issued with vouchers they can exchange for babysitting hours. If all of the parents simultaneously decide to save their vouchers, the system will grind to a halt. "My spending is your income, and your spending is my income. If both of us try to slash our spending at the same time, then we are also slashing our incomes, so we don't actually end up saving more." We could issue more vouchers to everyone, to make them feel "richer" and encourage them to spend – which would be the circle's equivalent of quantitative easing. But if everyone is determined to save, the parents will hold on to the extra vouchers, and the circle still won't work. This is what's called a liquidity trap, "and it's essentially where we are now".

The same principles apply to the "paradox of deleverage". Debt in itself is not a terrible thing, he says. "Debt is one person's liability, but another person's asset. So it doesn't impoverish us necessarily. The real danger with debt is what happens if lots of people decide, or are forced, to pay it off at the same time. High debt levels make us vulnerable to a crisis – and this is when you get the self-destructive spiral of debt deflation. If both of us are trying to pay down our debt at the same time, we end up with lower incomes, so the ratio of our debt to our income goes up."

Crucially, Krugman continues, "what's true for an individual is not true for society as a whole". The analogy between a household budget and a national economy is "seductive, because it's very easy for people to relate to", and it makes some sense when we're not in the grip of a macro-economic crisis. "But when we are, then individually rational behaviour adds up to a collectively disastrous result. It ends up that each individual trying to improve his or her position has the collective effect of making everybody worse off. And that's the story of our times."

At these moments someone has to start spending – and, Krugman argues, it is the government. But we're endlessly being told by the coalition that it has to pay off its debts because servicing the interest is ruinous, and the bond markets will destroy us unless we're seen to be tackling the deficit.
"Well, now. We know that advanced economies with stable governments that borrow in their own currency are capable of running up very high levels of debt without crisis. And we know it, actually, best of all from the history of the UK – which spent much of the 20th century, including the 30s, with debt levels much higher than it has now."

But what about bond markets? Invoked as global bogeymen, we're warned that they punish governments who fail to cut spending – even if cuts don't reduce the deficit. I've never understood why the markets should care how and when we reduce the deficit, as long as we can pay our way. According to Krugman, they don't.

"That's the interesting thing. The actual verdict of the markets, for countries that have their own currencies, has been that they don't really care at all in terms of what you're doing in short-run policy." Likewise, the danger of being downgraded by a credit rating agency has been wildly overstated. "We saw it in Japan in 2002; they had the downgrade, and nothing happened. Which led us to predict that would happen for the US," whose credit rating was downgraded by one agency last year. "And it was exactly right. Nothing happened."

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