Krugman on the Crash: What is to Be Done?

Just what is the problem with the economy? Obviously things are in crisis and collapsing. So the job of a government is to step in and save us from ourselves (as individuals, our impulse is to hunker down to survive the howling winds of economic carnage, but that is exactly the opposite of what is needed). The government has two tools:

1. Fiddle the monetary system (the Federal Reserve can push interest rates up or down, or do "quantitative easing" by printing money)
   
2. Fiddle the fiscal system (replace the missing private consumption with public consumption through "make work" projects)
   

Here's Paul Krugman's basic picture:

The Taylor rule, familiar to macroeconomists, is both a prescription and description of the Fed’s behavior. It says that the Fed should “lean against” both the business cycle and deviations of the inflation rate from a target of roughly 2%, raising interest rates when actual GDP exceeds potential GDP or inflation exceeds the target, cutting rates when the reverse is true. As the figure above shows, the GS version of the Taylor rule tracks actual Fed behavior very well — up to now.

But looking forward, the Taylor rule says that the Fed should cut rates a lot from here — in fact, to negative 6%. That’s not surprising: we’re clearly opening up a huge output gap, inflation is turning into deflation.

The problem, of course, is that you can’t cut interest rates below zero (if you try, lenders will just hoard cash.) So the Fed simply can’t do what the rule says it should.

This is why we need a huge fiscal stimulus, unconventional monetary policy, and anything else you can think of to fight this slump. Quite literally, the usual rules no longer apply.

Here's a video of a talk Paul Krugman gave in New York on Friday January 16, 2009. This is a very plain talk presentation of the problem by a Nobel Prize winner (2008) in Economics. As he points out: we are now living in a Wiley Coyote moment when we look down and realize that there is no support in the private sector to keep this crash from becoming The Great Crash. So the government has to step in and save us. Notice how Krugman is very, very worried that Obama isn't talking about doing enough: "[Obama's] talking Churchill defending the beaches on the economy, but he's proposing something that, although it is big by any normal standards, does not look adequate to the scale of the crisis we are now facing".