Princeton University economist and Nobel laureate Paul Krugman made his bones as a scholar of international trade issues.
Unfortunately, what he has gleaned from the interactions of currencies and international capital flows makes him decidedly pessimistic about what lies ahead for the U.S. economy. Against a climate where most expect a recovery and where policy makers are laying the groundwork for an eventual unwind of the unprecedented stimulus of the last two years, Krugman reckons the odds are good that years of moribund activity lie ahead for the U.S.
“I’m deeply worried about what comes from here,” Krugman said, speaking at the American Economic Association’s annual conference in Atlanta Monday. Recoveries caused by an unwinding of excessive financial sector borrowing are typically “slow and painful” but they also usually are joined by a currency devaluation that helps drive up exports.
In this experience, the U.S. is also facing a deleveraging crisis. While the dollar has been under pressure, it has done so in an environment of weak global growth. As a result, Krugman said, the U.S. is unlikely to get the sort of export growth that traditionally is the engine of recovery. That’s true even with a currency under pressure, he said.
Looking across financial history, Krugman said, “we don’t really have a lot of role models” for a positive outcome. One can look to Japan, which is not a heart-warming story, he said, adding “the only other role model is the Great Depression, which was ended by a very large fiscal stimulus project called World War II.”
Krugman’s pessimism is further rooted in what he believes was an insufficient government reaction to the crisis. The economist said “radical” spending action beyond 2009’s $800 billion fiscal stimulus was needed. He said some of the banks saved by government capital injections should likely have been nationalized and forced to lend to businesses at higher levels.
Krugman also said the Federal Reserve should have been even more aggressive with its asset purchases, especially since interest rate policy has largely become ineffective. The asset-buying effort is set to wind down in the first quarter of this year, and many in markets are worried about rising mortgage rates once there is an exit by the central bank, currently the largest buyer in this hard-hit sector. Krugman said the Fed should also be willing to tolerate a higher level of inflation.
What’s more, Krugman said, a further drop in the dollar would be a good thing, and he even welcomed China selling the currency, all as a way to help rebalance and stimulate the economy.
Krugman’s views count as particularly grim amid a community of economists who generally expect some sort of growth this year. While many of the most well-known economists attending the AEA meeting this year were gloomy — Harvard University’s Martin Feldstein worried about a drop back into recession — most forecasts see growth moving along at a modestly positive course over this year and next.
Krugman’s warnings came on a day where a key report on factory activity in December expanded at its fastest pace in more than three years. Hiring data for the last month of the year comes on Friday, and many are expecting a further moderation in job losses, which is itself welcome relative to the huge job declines seen over most of last year.
Time will tell if Krugman or the consensus view of forecasters prevails. But if the Princeton economist is right, 2010 will be a tough year, and the Fed will be forced to abandon the start of a normalization of policy that officials have been laying the ground work for over recent months. And that will be a tough thing for financial markets.
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