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Krugman and the crisis
I have followed the life and works of Professor Paul Krugman with great admiration. 1 admire him not because he is a Nobel Prize winner in Economics, nor because of the twenty odd books that he has written on this subject, nor because of his innumerable opinion pieces published in the
New York Times.
No, 1 admire him for his lucid intelligence and the concise manner he expresses himself. He has an enviable capacity to explain difficult issues in such a simple way that anyone can understand them. Besides his academic publications, the two books written for the general public that made a great impression on me were The Age of Diminished Expectations: U.S. Economic Policy in the 1990s and The Great Unraveling :Losing our way in the New Century (2003), in which he predicted that Bush's tax cut policy, continuous deregulation in the financial market under the long tenure of Alan Greenspan and the war in Iraq would have serious consequences for the economy of the United States and subsequently for the world economy as a whole.
So when Krugman came to Madrid to make a presentation of his latest book End This Depression Now! and give a lecture on the crisis in the euro area at the Rafael del Pino Foundation, I went to listen to him.(I remembered that I had visited this place before to listen to another Nobel laureate, Professor Muhammad
Yunus.)
It was an unforgettable experience. The huge auditorium of the foundation was completely packed. The authorities had prepared two adjoining rooms for the rest of the guests to follow Krugman through closed-circuit television. His visit had aroused so much enthu-siasm and expectation among economists, bankers and other professionals of the financial sector that soon these two rooms also became full.
Krugman did not disappoint the audience. His performance was absolutely brilliant. To lay the groundwork for a serious analysis of the economic situation, he gave an overview of several economic theories. In the context of this short article, I shall mention only two of them that I consider most relevant.
Referring to the current economic situation in the euro area, where demand continues to fall inexorably, Krugman said that about a couple of years ago, this area reached a critical moment (the Minsky moment). According to Professor Hyman Minsky, another renowned economist, this moment, unfortunately, is of
great importance because once a country reaches this stage, debtors cannot spend because they have no money and the creditors do not spend because they have lost confidence in the system. In other words, after this critical moment demand would continue to fall. So the question is: How does one get out of this disastrous situation?
There is no doubt that Krugman is a convinced Keynesian. According to Keynes aggregate demand is the principal factor that determines economic activity and growth. Therefore, in times of crisis, instead of imposing a severe austerity plan, what is needed is to stimulate demand through public expenditure, for example in infrastructural developments etc., by the government. In order to avoid any misunderstanding, Krugman insisted that he was neither in favour of structural budget deficits nor profligate spending.
According to Krugman, within the overall context of
the euro area, Spain has got several specific problems which are interrelated: the fiscal deficit, the very high risk premium being paid to finance the deficit, the huge hole in the finances of the banking sector because of the collapse of the real estate business, which by the way, has forced the government to seek multi-million dollar bailout funds from Brussels and, of course, the absence of a central bank with the powers and attributes of a real central bank like the Federal Reserve. At this point Krugman emphasised that the difference between the US dollar and the euro is the absence of a true federal government in the euro area. As a result, the euro area does not have an organisation which is empowered to carry out all the functions of a normal central bank. As this subject is crucial for the resolution of the crisis, it is worth developing it. What are the functions of a central bank?
Since the Bank of England is considered as one of the oldest and most prestigious central banks of the world, it would be a good idea to review its functions.
Perhaps the most important responsibility of the Bank of England is to manage the country's monetary policy. One of the instruments used by the Bank of England to control the total amount of money and credit available in the financial market at any given point of time is the interest rate. An increase in the benchmark rate usually results in cutting expenditure and saving more. Lowering the interest rate tends to stimulate the economy and encourage demand, output and employment.
Even though the ECB has recently lowered the
benchmark rate from 1% to 0.75%, the absence of several factors such as a true banking union, "mutualisation" of sovereign debts and a full deposit insurance fund has opened a wide gap between the debtor countries of the south and the creditor countries of the north of Europe. While the creditor countries pay interest at a lower than benchmark rate, the debtor countries are forced to pay interest well above that rate, which further hinders economic recovery.
According to Krugman, under the present circumstances the only way to lower the borrowing costs, to reduce capital flight and to fight against the speculators is for the ECB to intervene directly into financial market by buying sovereign debts. Following the examples of the Federal Reserve, the Bank of England and the Japanese Central Bank, Krugman recommended the use of "Quantitative Easing" (printing new money) for this purpose. He said that he was aware of the fact that this policy could increase inflation, but thought that an inflation of up to 4% in Germany would help economic recovery in the euro area as a whole.
Besides being the bank of other banks and financial institutions, the Bank of England supervises and regulates the banking industry of the country. It is also responsible for managing the national debt. One of its most important functions is to fulfill the role of the lender of last resort to those entities which cannot obtain credit anywhere else and whose collapse would have serious consequences for the economy.
Analyzing the recent activities of the ECB, one may conclude that its main concern is to control inflation. Of course, in macroeconomic terms, controlling the inflation is important. But Krugman thought that the ECB had to do much more. European governments must take urgent measures to equip the ECB with all the powers mentioned above. If not, the crisis will continue.
The writer is an Officer of the Order of Queen Isabel la Catolica of Spain and a columnist of The Daily Star.