By Julia Zuckerman M.P.A. '11

Paul Krugman, a professor of economics and international affairs at the Woodrow Wilson School and the 2008 Nobel Prize winner in economics, provided an update on the state of the economy to an audience of approximately 300 Wednesday, Oct. 21 in McCosh Hall.

(Click here for video and audio of Krugman's talk)

Krugman's lecture, sponsored by WWS and titled “The Return of Depression Economics?”, was based on his latest book, “The Return of Depression Economics and the Crisis of 2008.” The book was originally published in 1999, and dealt with the Asian financial crisis.  Krugman said during his talk that Americans failed to learn the lessons of that crash, which also began with the bursting of a speculative investment bubble and which caused lasting economic damage in the affected countries.

As the economy collapsed in late 2008, “we basically replayed the first year of the Great Depression,” Krugman said. A year later, he noted, the economic plunge has stopped. “This doesn’t mean things are OK – far from it – but it means Great Depression 2.0 is not about to happen,” he said. 

But Krugman cautioned that the rules of “depression economics” are still in effect, with the economy stuck in a cycle where ordinary economic rules and policies do not apply. For example, he said one of the standard strategies for encouraging economic growth is for the U.S. Federal Reserve to cut interest rates. With interest rates at zero percent, that policy tool is no longer available, leaving the U.S. economy stuck in a “liquidity trap,” he noted. Economists watching current economic trends are concerned about deflation, not inflation.  And deficit spending by government, usually frowned on by economists, becomes a necessary tool to restart economic growth.

“It's hard to get people to wrap their minds around how different things are from normal right now,” he said. “It becomes almost an Alice-through-the-looking-glass world, economically."

According to Krugman's analysis, the United States is in for a rough few years.  He pointed to the example of Japan, which spent a decade after the 1997 financial crisis trapped in a pattern of sluggish growth, high unemployment and deflation, with standard policy solutions failing to turn the economy around. “I am worried about a Japanese-style 'lost decade,’” he said.

Krugman warned, “This crisis in the broad sense is going to drag on for years. We're going to be living in depression economics for a long time.”

But after spending much of the last eight years criticizing the Bush administration’s economic policies, Krugman said he trusts and for the most part agrees with the Obama administration’s economic team – including Fed chair Ben Bernanke, who was the chair of Princeton’s economics department and a WWS professor before moving to the Fed. Krugman credited Bernanke with implementing lessons learned from the Asian crisis; he recalled that during that crisis, he and Bernanke were among a small group of Princeton economists who were alarmed by the Japanese experience and worried that it could happen to the United States and Western Europe. Bernanke subsequently published a series of papers about Japan’s dilemma that, Krugman said, now seem to be serving as the Obama administration’s blueprint for action on the current crisis.

Krugman has frequently criticized the stimulus program as being too small, but he said it nonetheless has made a significant impact.  “Deficits saved the world this time around. It doesn't mean they're always good, that they're sustainable indefinitely, but they helped,” he said.

He was less optimistic about financial reform and said it will be crucial to find ways to regulate the “shadow banking” system, which was responsible for much of the explosion in credit during the bubble. He said that without reform, the bailout may be encouraging even more risky behavior, because after the collapse of Lehman Brothers and the decision that some banks were “too big to fail,” there is a widespread assumption that any large financial institution will be backed by taxpayer money.

During a question-and-answer session, several questioners expressed concerns about inflation and about China’s willingness to hold large reserves of U.S. dollars. Krugman said developments that would be dangerous during better economic times – such as China selling off some of its dollar reserves, or a rise in inflation – would be welcome as economic stimulus now.

“There will come a time when we need to be conventionally responsible again,” Krugman said. But he summarized his approach with a quote from St. Augustine: “Lord, make me chaste – but not yet.”