Paul strikes again…

Paul Krugman’s London lectures
The Nobel laureate speaks on the crisis in the economy and in economics

THE London School of Economics was once so popular among young American scholars that British students used to joke that LSE stood for “Let’s See Europe”. A distinguished sightseer, Paul Krugman, returned to the LSE on June 8th to give the annual Lionel Robbins memorial lectures. Mr Krugman, who gave the Robbins lectures 21 years ago, tried to answer two big questions in the course of his three talks. Why did economists not foresee calamity? And how will the world economy climb out of recession?

The immediate cause of the crisis, “the mother of all global housing bubbles”, was spotted by many economists. That house prices had risen too far was obvious, even if policymakers had seemed less sure. The surprise was that the bursting of the bubble would be so damaging. “I had no idea it would end so badly,” said Mr Krugman.

One big blind spot was the financial system. The mistake was to think “a bank had to look like something Jimmy Stewart could run”, with rows of tellers taking deposits in a marble-fronted building. In fact a bank is anything that uses short-term borrowing to finance long-term assets that are hard to sell at a push. The shadow banking system was as important to the economy as the ordinary kind, but was far more vulnerable. Its collapse was the modern re-run of the bank failures of the 1930s, said Mr Krugman.

The excess borrowing that did for shadow banks threatens consumers, too. They are scrambling to save more as house prices plunge. Their mortgage debts loom larger because of vanishing inflation. This urge to shore up wealth is self-defeating in aggregate, as it curbs spending and incomes. It also renders conventional monetary policy impotent, as the interest rate that prevents too much saving is below zero.

That creates a role for fiscal policy. If zero interest rates cannot get consumers to spend, then governments must spend instead. That remedy comes from economics so the discipline is not without merit. The trouble is, “the analysis we’re using is decades old”. It dates back to Keynes, one of the few economists whose reputation has been burnished by the crisis. (Another is Hyman Minsky, whose main insight was that stability leads to too much debt, and then to collapse.) Most work in macroeconomics in the past 30 years has been useless at best and harmful at worst, said Mr Krugman.

As for the economy, the road back to health will be long and painful. The big lesson from past bubbles is that recovery is export-led, which is not helpful “unless we can find another planet to export to”. Otherwise, recovery will have to wait for savings to be rebuilt, and that will not happen quickly. Higher inflation than before the crisis might help, he said.