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Paul Krugman's Solution to the Debt Problem: Government Spending

Paul Krugman and Gauti Eggertsson of the New York Fed have a new paper out arguing that the recession and persistent unemployment could have been ameliorated by aggressive government spending. It'll be getting lots of attention, I suspect, so you might as well start reading it now.

Paul Krugman
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Paul Krugman

"The model, and more broadly overall logic, suggests that there is good no reason [sic] why the economy has to suffer a large loss of output and employment after a Minsky moment. The capacity is there, and nothing about the fact that some people have too much debt makes it impossible to use that capacity to produce goods and services for other people.

But the policies that can prevent that gratuitous slump — a commitment to higher inflation over the medium term, and/or deficit spending — run right up against ingrained prejudices. The foundations for the shock were laid by a long period of relative stability, especially low inflation; it’s very hard for policy makers to accept that what was good in 2000 or even 2007 is no longer at all good now that Minsky has struck. And everyone has just seen the punishment for too much debt; asking others to run up debt to help fix the problem, even though it’s right, is unavoidably a tough sell.

We might nonetheless have been able to get through this with less damage if we’d had strong leadership and clear thinking from the economics profession. But as it was …

Anyway, if you want to know what’s lurking behind what I say about our economic mess, now you know."

I'm still working my way through the equation-heavy paper. But for now, let me say that I agree: government spending can increase the economy's output. The problem is that the spending is likely to be misdirected and maladaptive, aimed at political priorities rather than satisfying genuine economic demand. This isn't just a short-term problem, either.

As the economy gets directed around government spending, financial and human capital are mal-invested. Workers learn skills for which there is not enough natural demand, so that when government spending stops the unemployment problem arises once again. Investors, too, wind up committing capital to projects that turn out to be unprofitable once stimulus is removed. In short, at the zero-interest-rate boundary, stimulus has the same distorting effects that artificially low interest rates have on the economy.

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