Slump not the same as meltdown, says expert

A top US economist put the downturn into perspective. GAVIN ELLIS reports.

First, the good news. One of the United States' foremost economists believes the economic effects of the terror attacks of September 11 will be less widespread than people think.

Now the bad news. The same economist, Professor Paul Krugman, of Princeton University, thinks the US - and hence the world - was in big trouble before that date.

Worse, it was a situation for which the world was not well prepared because it had come to believe that short-term downturns were not very important.

Krugman predicted the Asian crisis of 1997-1999 and was vilified in many Asian capitals until his prophecy came to pass. Now he visits those same capitals with more than a degree of "street cred".

He was in Seoul last week addressing the World Knowledge Forum, alongside the Director-General of the OECD, Donald Johnston, and Mike Moore's successor at the WTO, Supachai Panitchpakdi.

Today he somewhat minimises the Asian crisis.

"It appeared very serious, then [Federal Reserve chairman] Alan Greenspan said the right words and it seemed to evaporate."

But the environment confronting economies today is one that Krugman believes is less amenable to control. And he cites Japan as an example. While other Asian economies have overcome the effects of recession, Japan continues to be what Krugman calls a "disturbing model" that demonstrates the ineffectiveness of monetary policy.

He contends that Japan found itself in a liquidity trap: even zero interest rates were insufficient to stimulate demand. In other words, conventional regulatory tools were not enough to kick-start the economy.

With Greenspan methodically slashing interest rates, such comments may sound chilling. But Krugman has a little more good news. He thinks the present downturn in US performance is different, and driven by a different sort of business cycle.

"It is," he says, "something we have not seen for 40 years - a classic downturn. Since the 1960s, every boom has been ended by a deliberate action. It has been choked off by a central bank concerned about inflation.

"This time, basically, the boom has been allowed to run its course, largely because it did not produce inflation."

He thinks it unlikely that monetary policy alone will solve America's problems, either. But there are some important differences between the US and Japan. There has been no real estate bubble and no comparable build-up in debt.

US business is in a position where it invested too heavily during the good times, particularly in IT systems.

"So, business has invested too much and will take some time to work off that overhang," Krugman says. "The question is, how do we get through that without translating it into a more broadly based slump?"

Traditionally, the first line of defence has been monetary policy, and Krugman acknowledges it needs to be deployed.

"We are conditioned to think that central bankers can work magic. We expect that if someone can talk the self-fulfilling pessimists around, then the problem will evaporate. Greenspan has tried the magic eight times now, but this isn't about pessimism. It's about getting rid of that overhang."

Ironically, Krugman believes America is beset by what he calls "self-defeating optimism" - an outlook that has prevented long-term interest rates from falling.

Krugman's assessment: monetary policy is not enough to turn things around and fiscal policy needs to be used as an economic weapon.

He places little store by tax cuts. Permanent cuts affect the budget balance and temporary cuts tend not to be spent.

His answer: Government spending.

In part, that will come through the rebuilding of New York's financial district, spending on security and infrastructure, but there may need to be other large but temporary increases in federal spending.

Meanwhile, the political indicators are looking worse, and the Bush Administration is talking tax cuts as a stimulus rather than a huge injection of federal spending.

But Mr Krugman, a somewhat self-effacing academic, is not one to leave an assessment of the economic outlook on a completely sour note.

"We have a temporary problem," he says. "It is not a meltdown, it is not stagnation. It is a legacy of the excesses of the late 1990s."

The pace of the slowdown and the speed of recovery will largely depend on whether partisan politics play too large a part.

* Gavin Ellis was a speaker at the World Knowledge Forum.