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Krugman Analysis

Essay Topic:

The Story Behind Financial Deregulation a. Wild Optimism & the Deregulation Movement b. The Political Influence of the Financial Sector (and the Wealthy in General) PART II: THE SOLUTION Section 3: The Solution is Government Stimulus (and a Few Other Reforms) 7. The Solution is Government Stimulus 8. Objection #1 : Government Stimulus Doesn’t Spur the Economy (and Response) ; a. Exhibit A: The Great Depression b. The Initial Stimulus Effort Was Too Small 9.

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Solution Specifics a. Stimulus Specifics b. Additional Federal Reserve Actions c. Housing Relief (et. L. ) 10. Objection #2: The Danger of Government Debt (and Response) ; . The Problem of Investor Confidence b. The Problem of Paying off the Debt in the Future 1 1 . Objection #3: The Danger of Inflation (and Response) Section 4: The Chances of Government Stimulus Being Implemented (and How to Improve Them) 12. Pragmatic Politics and the Coming Election a. An Obama Sweep b. An Obama Win, and a Divided Parliament c. A Rooney Victory 13. Conclusion Since the housing and financial crash of 2008, America’s economy has been stuck deep in the doldrums.

Indeed, GAP has remained well beneath pre-2008 levels, and employment levels have failed to recover. In an effort to resuscitate the economy, the American government tried first to Jump-start it through stimulus spending, and has now replaced this approach with greater austerity. Nothing seems to be working. For Nobel Prize winning economist Paul Grumman, though, the answer is clear: the problem is that the original stimulus effort was too small, and, since that time, the government is moving squarely in the wrong direction.

Indeed, Grumman argues that America’s current situation bares a striking resemblance to the stagnation of the Great Depression, and that history has taught us what to do in such situations: the overspent must take an aggressive approach to stimulate the economy into recovery. This is the argument that Grumman makes in his new book ‘End This Depression Now! ‘ Now, Grumman is not a proponent of big government spending under normal conditions. Indeed, even in a recession, German’s preferred approach is to drop interest rates in order to spur consumer spending.

The problem now is that interest rates are already at zero, and this has not been enough to get consumer spending off the ground, thus leaving the economy in what is called a ‘liquidity trap’. For Grumman, the liquidity trap is actually quite common in economic downturns that allow financial crashes (as is the case with the current one, and as was the case with the Great Depression), and is why such slumps tend to be deep and prolonged. According to Grumman, the best and surest way to save the economy from a liquidity trap is for the government to step in and undertake the spending that consumers won’t.

That is, the government must stimulate the economy back into action, until consumers can get back on their feet enough to take over for themselves. For Grumman, this is precisely what happened in America during WI, when the government’s military spending served to stimulate the economy and save it from the rips of the Great Depression. Now, German’s opponents will point out that the American government has already tried the stimulus approach during this downturn, and that this strategy did not work, thus showing that it cannot be relied upon.

What’s more, these same opponents argue that the government’s debt is already enormous, and indeed dangerously high, and that further government spending at this point may well render the debt completely unmanageable, if not force the government into insolvency (which is indeed a threat that is currently being faced by several countries in the European Union). Finally, German’s detractors maintain that pumping more money into the economy at this time only threatens to drive up inflation to dangerous levels, perhaps even triggering a hyperinflation spiral.

Grumman, though, claims that he has answers to all of these objections. In the first place, as noted above, the author maintains that the failure of the government’s first stimulus effort did not prove that this approach is ineffective, but that it simply wasn’t large enough to do the trick. Second, Grumman argues that though government debt does pose a concern, America’s debt is actually not that dangerous by historical tankards. What’s more, since America has its own currency (unlike the countries of the European Union), it is able to print money to turn over its debt, thus preventing the possibility of bankruptcy.

Finally, with regards to inflation, Grumman contends that inflation simply cannot get off the ground in a depressed economy (as the current situation would attest to), and that when it is triggered in an upturn the government can always reverse its policy, thus keeping it firmly in check. Here is Paul Grumman speaking about his new book (Part II of the interview is available on Youth): http://www. Tube. Com/watch? What follows is a full executive summary of End This Depression NOW! By Paul Grumman.

PART l: THE PROBLEM Grumman begins by way of establishing the gravity of the problems that America’s economy is currently facing. This can be seen in the numbers. To begin with, consider America’s Gross Domestic Product (GAP). As Grumman notes, GAP indicates “the total value of goods and services that are produced in an economy, adjusted for inflation… In a given period of time” (loc. 274). As such, GAP provides a general picture of how much an economy is producing, and how quickly it is growing.

Between the Great Depression and the beginning of the current recession, America’s GAP grew at an average rate of between 2% to 2. 5% per year (loc. 277). The biggest downturn during this time occurred between 1979 and 1982, when America’s economy experienced a ‘double dip’ recession-?which Grumman characterizes as essentially “two recessions in close succession that are best viewed as basically a single slump with a stutter in the middle” (loc. 283). At the low point of this recession, in 1982, America’s “real GAP was 2 percent below its previous peak” (loc. 83), meaning it basically went flat. However, the author continues, the economy rebounded very quickly in the immediate aftermath, “growing at a 7 percent rate for the next two years-?morning in America’-?and then returned to its normal growth track” (loc. 283). When we look at the latest recession, we find that the low point occurred between 2007 and 2009. When compared with the recession of the late sass’s and early sass’s, we find that the latest “plunge… As steeper and sharper, with real GAP falling 5 percent over the course of eighteen months” (loc. 287). What’s more, the American economy has not seen a strong recovery this time around, as “growth since the official end of the recession has actually been lower than normal” (loc. 287). All in all, the author claims, “the U. S. Economy is [currently] operating about 7 percent below its potential” (loc. 295), and has lost $3 trillion in value since the slump began (loc. 299).

Most significant of all, though, is that the economy shows no signs of a major come back any time soon; thus leading Grumman to conclude that “at this point we’ll be very lucky if we get away with a cumulative output loss of ‘only $5 trillion” (loc. 299). . Unemployment Is Way Up While the GAP numbers are certainly telling, the more significant numbers, according to Grumman, are those concerning unemployment. As the author reminds us, unemployment statistics cover only those who are looking for work but who can’t find it, and “in December 2011 that amounted to more than 13 million Americans, up from 6. 8 million in 2007” (loc. 94). This is already a staggering number, but when you take into account all of those people who have stopped looking for work out of frustration, or who have taken part-time work out of desperation, this number balloons even Geiger: “by this broader measure there are about 24 million unemployed Americans -?about 15 percent of the workforce-?roughly double the number before the crisis” (loc. 202). And since the current slump has dragged on so long, the number of people who have been out of work long-term (meaning 6 months to 1 year, or longer [loc. 224]) has risen to levels not seen since the Great Depression.

Indeed, Grumman writes that “not since the sass’s have so many Americans found themselves trapped in a permanent stats of Joblessness” (loc. 228). The unemployment numbers are particularly important, the author argues, since hey bring home the human element of the story. Indeed, while GAP statistics represent the abstract loss of an entire economy, unemployment numbers reflect the loss of income of real people. What’s more, unemployment not only affects income, but self-esteem as well: “people who want to work but can’t find work suffer greatly, not Just from the loss of income but from a diminished sense of self-worth.

And that’s a major reason why mass unemployment-?which has now been going on for years-?is such a tragedy’ (loc. 173). Adding to the tragedy here is the fact that those who are shut out of the Job market or long stretches end up being stigmatize, which can hurt their prospects of landing work in the future: “Does being unemployed for a long time really erode work skills, and make you a poor hire? Does the fact that you were one of the long-term unemployed indicate that you were a loser in the first place? Maybe not, but many employers think it does, and for the worker that may be all that matters.

Lose a Job in this economy, and it’s very hard to find another; stay unemployed long enough, and you will be considered unemployable” (loc. 241). While all of these factors have very such affected people who were already in the Job market, it has been even worse for young people who had not yet established themselves before the recession hit. Indeed, unemployment levels among the young tend to be higher than the general population in the best of times, but in the worst of times they tend to get hit even harder. As Grumman notes, “truly , this is a terrible time to be young…

Roughly one in four recent graduates is either unemployed or working only part-time. There has also been a notable drop in wages for those who do have full-time Jobs that don’t make use of their education” (loc. 249-58). 3. The Potential Long-Term Consequences When it comes to the plight of young people, as well as those who have found themselves shut out of the Job market for an extended period, these phenomena not only affect those directly involved, but also threaten to damage the economy in the long term. This proves to be the case because, as mentioned, present unemployment, or underemployment, can threaten future opportunities.

As Grumman explains, “if workers who have been Jobless for extended periods come to be seen as unemployable, that’s a long-term reduction in the economy’s effective workforce, and hence in its productive capacity. The plight of college graduates forced to take Jobs that don’t use their skills is somewhat similar: as time goes by, they may find themselves demoted, at least in the eyes of potential employers, to the status of low- skilled workers, which will mean that their education goes to waste” (loc. 324). And lost employment opportunities is not the only way that a prolonged slump can adversely affect future economic performance.

As Grumman argues, an extended downturn tends to deter businesses from investing in and expanding their operations, which can leave them in a position where they are unable to meet emend when the economy finally does turn around and demand picks up: “the problem is that if and when the economy finally does recover, it will bump up against capacity limits and production bottlenecks much sooner than it would have if the persistent slump hadn’t given businesses every reason to stop investing in the future” (loc. 328).

German’s claim that an extended economic downturn does in fact have significant long time repercussions is bolstered by an MIFF study that looked at previous recessions. As the author explains, “the International Monetary Fund has tidied the aftermath of past financial crises in a number of countries, and its findings are deeply disturbing: not only do such crises inflict severe short-run damage; they seem to take a huge long-term toll as well, with growth and employment shifted more or less permanently onto a lower track” (loc. 41). Even more important, for Grumman, is that there is also evidence that a concerted effort to pull an economy up out of a slump can mitigate the future damage (loc. 341). For the author, then, the message is clear: America is in the midst of a very serious and damaging slump; the longer the country remains in the slump, the worse things ill be in the long run. As such, we must take swift and direct action to extricate the nation from the current situation.

Before we take a look at what form Grumman thinks this action should take, it well help to hear the author’s assessment of the current situation, and what he thinks landed the country here to begin with. According to Grumman, while America’s current situation is really quite dire, the reason why the country finds itself in this situation is really rather simple. It all has to do with demand: “why is unemployment so high, and economic output so low? Because we-?where by We’ I mean consumers, businesses, and governments combined-?aren’t spending enough… E are suffering from a severe overall lack of demand” (loc. 453-62). Actually, this whole scenario is unfolding as somewhat of a domino effect, as is the case with all downturns. To be specific, consumers have stopped spending, which means that businesses do not feel the need to hire more employees and/or ramp up production; and since production is down, governments are earning less revenue through taxes, and are themselves more reluctant to spend (loc. 459). So, how does a country get itself out of this kind of slump?

Under normal circumstances America’s Central Bank (the Federal Reserve), would pump more money into the economy, thereby lowering the interest rate (by the law of supply and demand) (loc. 554-59, 590). This has the effect of making credit cheaper, which spurs individuals to lower their savings and consumer more, thus pulling the economy out of the slump. As Grumman reports, this strategy has proven to be very effective over the years: “it worked spectacularly after the severe recession of 1981-82, which the Fed was able to turn within a few months into a rapid economic recovery -?morning in America.

It worked, albeit more slowly and more hesitantly, after the 1990-91 and 2001 recessions” (loc. 559). The problem this time around is that when the recession hit in 2008 interest rates were already at the rock bottom rate of zero percent, meaning the Fed could not lower them any further (loc. 594). Since that time the interest rate has remained at zero, but, through it all, even this has not been enough to spur consumer spending to the point where it has been able to rescue the economy from its slump.

When interest rates are at zero, and people still aren’t spending, you have what is called a ‘liquidity trap’. As Grumman explains, “it’s what happens when zero isn’t low enough, when the Fed has saturated the economy with liquidity to such an extent that there’s no cost to holding more cash, yet overall demand remains IoW’ (loc. 596). And for the author, this is the crux of the issue. According to Grumman, a major part of the problem this time around is that when the latest recession hit, a large number of Americans were already deep in debt due to the housing crash, as well as other personal debt.

What this meant is that even at zero percent interest a vast number of Americans could not afford to resume pending, for they had to get out of their debilitating debt first (loc. 755, 774, 2240). Nor is that the worst of it. Indeed, one of the most straightforward ways to get out of debt is to sell off your assets. But when a large number of people try to sell off their assets (including their houses) all at once, this drives down the price of the assets, thus reducing the amount of money that people can raise in order to pay off their debt, thus exacerbating the problem (loc. 63). But there’s more! As the prices of assets fall, the purchasing power of money correspondingly increases (called fellatio), and this increases the relative burden of debt (for the money that you are paying back your debt with is ever increasing in value), thus complicating the matter even further (loc. 767). 5. The Root of the Problem: The Deregulation of the Financial Sector Now, a lot has been made of the issue of how Americans came to be so indebted in the first place, for this was a major part of why the current problem is so bad.

Commentators on the right tend to blame borrowers who took out loans that they were not in a position to pay back, as well as government supported agencies who provided cheap loans to under-funded home-owners (loc. 059). Commentators on the left, on the other hand, tend to put the blame on deregulation in the financial industry, which allowed banking and investment companies to take on undue risk, as well as the banking and investment companies themselves who took advantage of the situation by way of providing loans to overly-risky borrowers. Grumman himself is primarily in the latter camp.

To begin with, Grumman claims that the vast majority of bad mortgage loans were made by private firms, not the much maligned government-sponsored Fannies Mae and Freddie Mac (loc. 1072); who, the author contends, got into the bad mortgage name only very late (loc. 1072), and not nearly to the extent that private companies did (loc. 1072). But the root of the problem, according to Grumman, is the steady deregulation of the financial industry that began under Reagan in the sass’s, and that culminated with the Grammar-Leach-Bailey Act of 1999, which repealed a provision of the Glass-Steal Act.

Glass-Steal was a bill passed in 1933 to deal with the ongoing Great Depression (loc. 977). The major provision in the bill was that commercial banking deposits would be insured up to a certain point by the federal government (loc. 977). This was meant o restore confidence in banks, many of whom had fallen to bank runs in the previous years (loc. 977). The issue with insuring bank deposits, though, is that this creates a moral hazard for the banks. For the banks know that they will ultimately be bailed out by the government (meaning taxpayers) if they fall into insolvency (loc. 86); and, as such, they are tempted to make overly-risky investments. As Grumman explains, “it could have created a situation in which bankers could raise lots of money, no questions asked-?hey, it’s all government insured-?then put that money into high-risk, high stakes investments, curing that it was heads they win, tails taxpayers lose” (loc. 986). In order to protect against this moral hazard, the legislators behind Glass-Steal also included a provision that stipulated that commercial banks could not act as investment banks. This was meant to keep commercial bank deposits safe from overly-risky investments.

As Grumman notes, “any bank accepting deposits was restricted to the business of making loans; you couldn’t use depositors’ funds to speculate in stock markets or commodities, and in fact you couldn’t house such speculative activities under the same institutional roof” (loc. 990). In 1999, though, this provision of the Glass-Steal Act was repealed by the Grammar-Leach-Bailey Act (loc. 1017). According to Grumman, this move was the height of irresponsibility, and was a major contributor to the extreme risk-taking environment that led directly to the financial crash of 2008 (loc. 007-1017). For the author, though, the repealing of Glass-Steal was not the only article of deregulation that prompted the crash. Indeed, he identifies several pieces of anti-regulatory legislation that also had a hand to play in triggering the whole mess, from President Carter’s Monetary Control Act of 1980 (“which ended isolations that had prevented banks from paying interest on many kinds of deposits” [loc. 1003]); to President Reggae’s Garn-SST. German Act of 1982 (“which relaxed restrictions on the kinds of loans banks could make” [loc. 003]); to the failure of legislators to keep up with new innovations in the financial industry, such as shadow banks (loc. 1029-42). Now, unlike some left-wing commentators, Grumman is not prepared to let consumers off the hook entirely for the debt problems that complicated the crash. Indeed, the author (following the economic thinker Hyman Minsk) argues that a big actor behind the growth of consumer debt in the recent past was a general natural tendency for people to forget about the dangers of debt during good times (loc. 733, 798-815).

As Grumman explains, “an economy with low debt tends to be an economy in which debt looks safe, an economy in which the memory of the bad things debt can do fades into the mists of history. Over time, the perception that debt is safe leads to more relaxed lending standards; businesses and families alike develop the habit of borrowing; and the overall level of leverage in the economy rises” (loc. 810). As the quote makes clear, the optimism in question touched all Americans, not Just the lenders, and so all involved deserve some share of the responsibility (loc. 33, 806). 6. The Story Behind Financial Deregulation According to Grumman, though, it was ultimately the lack of regulations that allowed this selective memory and wild optimism to become dangerous, for the regulations were essentially keeping these sentiments in check (loc. 838). Now, it may rightly be said that the same emotions that led to growing debt also influenced the legislation that allowed it to become dangerous in the end (loc. 40). But for Grumman, there were other reasons behind financial deregulation that are also important to consider.

For one, even before regulations were removed from the financial sector, the government had already begun to deregulate other industries (such as air travel, trucking, and oil and gas) (loc. 999-1003). These reforms had led to significant gains in efficiency in these industries (loc. 999), and thus many were optimistic that the same approach would work in the financial sector. The problem, as Grumman points out, is that “banking is not like trucking, and the effect of deregulation was not so such to encourage efficiency as to encourage risk taking” (loc. 007). B. The Political Influence of the Financial Sector (and the Wealthy in General) Over and above the factors mentioned above, though, Grumman argues that there is a still more sinister explanation behind the deregulation of the financial sector. And this has to do with the political influence of those who benefited most from it: the bankers themselves. Take the Grammar-Leach-Bailey Act of 1999, for instance (which, you will recall, revoked a crucial regulatory provision of the Glass-Steal Act).

As Grumman points out, the gassing of the Act was largely influenced by the lobbying of Citron and Travelers Group, who in 1998 had wanted to amalgamate to become Citreous, but who had encountered obstacles due to Glass- Steal (loc. 1043, 1357-65). And even before this, the political elite stood in defense of increasing deregulation, despite initial indications that the measures were problematic (loc. 1414, 1130). Indeed, as Grumman is wont to stress, the problems posed by deregulation did not begin with the financial crash of 2008.

Instead, they began to surface even in the sass’s when the banking sector was first deregulated. For instance, in 1989 the Federal government was forced to shut down the thrift banking industry due to a collapse induced by bad debt (loc. 1099-1120). A desperate move that put taxpayers on the hook for $130 billion (loc. 1120). Then, in the sass’s, further difficulties arose when several large commercial banks over-extended themselves “in lending to commercial real-estate developers” (loc. 1119).

Finally, “in 1998, with much of the emerging world in financial crisis, the failure of a single hedge fund, Long Term Capital Management, froze financial markets in much the same way that the failure f Lehman Brothers would freeze markets a decade later” (loc. 1123). For Grumman, all of these events should have acted as clear warning signs that there was something seriously wrong with financial deregulation (loc. 1 125-30). So why did the political elite fail to heed the warning signs? For Grumman, this become a good deal more understandable when we appreciate how profitable deregulation was for the financial sector (loc. 142), and how much influence this sector has on government. Indeed, as the author points out, while deregulation did virtually nothing to increase the incomes of middle class families (loc. 137, 1190), the move was a great boon to the wealthy (loc. 1142, 1201), and especially the bankers themselves (loc. 1300, 1418). In addition, it’s no secret that the wealthy, and the financial sector in particular, has a major influence on government (loc. 1351). This influence exists not only in the form of significant monetary contributions (loc. 346), but in the two-way cross-over between the financial sector and political office (loc. 1380, 1392). What’s more, the influence of the wealthy has been increasing as the rich have gotten richer since the time when deregulation first took off (loc. 1388). Section 3: The Solution is Government Stimulus (and a Few Other Reforms) 7. The Solution is Government Stimulus Grumman certainly maintains that reforms in financial sector regulations are needed if the country is to avoid falling into future debacles such as it finds itself in presently.

For him, though, the more important question has to do with how to get the country out of its current situation. As you will recall, Grumman contends that America’s problem now is that it is in the midst of a liquidity trap. That is, interest rates are already at zero, and yet this still isn’t enough to reignite consumer pending. What’s more, since consumers aren’t spending, businesses have no reason to hire workers and/or expand their operations, and so they aren’t spending either (loc. 461). Any yet, for Grumman, this lack of spending is very much the heart of the problem.

So what can be done? According to Grumman, the answer is simple: the government must step in and take over the role of spending (loc. 879). As the author puts it, “the essential point is that what we need to get out of this current depression is another burst of government spending. Is it really that simple? Would it really be that easy? Basically, yes” (loc. 688). German’s argument is that government spending will put money into the hands of the people, who will then be able to recover enough to resume spending themselves.

As consumer spending increases, businesses will increase production and hire more workers, thus fully pulling the economy out of its current slump (loc. 679). 8. Objection #1 : Government Stimulus Doesn’t Spur the Economy (and Response) Now, some argue that government spending doesn’t actually increase demand and spur the economy at all, since, they claim, all it really does is take resources from one sector of the economy and transfer them to another.

The argument is well-rendered by Brian Riddle of the right wing thing tank the Heritage Foundation, who Grumman quotes in his book: “the grand Keynesian myth is that you can spend money and thereby increase demand. And it’s a myth because Congress does not have a vault of money to distribute in the economy. Every dollar Congress injects into the economy must first be taxed or borrowed out of the economy. You’re not creating new demand you’re Just transferring it from one group of people to another” (loc. 474).

Now, for Grumman, this argument may hold true under normal circumstances, when banks are lending and companies are competing for resources (loc. 2369). But in a depressed economy this is not the case. Rather, in such a situation banks are not lending because safe investments net very little profit, and risky investments are, well, too risky (loc. 2369). So in a depressed economy, resources go unused by the private sector (loc. 2079). This being the case, government spending does not displace private spending; rather, it does nothing but increase demand

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