On Sunday, I talked about about Wall Street's wild week with two of the world's top economists. We discussed what the market volatility means or doesn't mean, and what may lay behind it and what lies ahead of us.
Paul Krugman won the 2008 Nobel Prize in Economics, and he is a columnist for The New York Times. Kenneth Rogoff is a former chief economist at the International Monetary Fund, now a professor of economics at Harvard University. Here's a lightly edited transcript of our conversation:
Fareed Zakaria: Paul, let me start with you. The one thing we saw over the week was markets up, markets down, but the one trend that seemed persistent was there is a great demand for U.S. treasuries despite the fact that the S&P downgraded it.
You've been talking a lot about this. Explain in your view what does it mean that in moments like this U.S. treasuries are still in demand and what that does is push interest rates even lower than they are.
Paul Krugman: Well, what it tells you is that the investors, the market, are not at all afraid of what the policy elite or people like Standard & Poor's are telling them they should be afraid of.
You know, we've got all of Washington, all of Brussels, all of Frankfurt saying debt, deficits, this is the big problem. And what we actually have in reality is markets are terrified of prolonged stagnation, maybe another recession. They still see U.S. government debt as the safest thing out there, and are saying, if this was a reaction of the S&P downgrade, it was the market's saying, "We're afraid that that downgrade is going to lead to even more contractionary policy, more austerity, pushing us deeper into the hole."
So it's a reality test, right? So we just had a wake-up call that said, "Hey, you guys have been worrying about the entirely wrong things. The really scary thing here is the prospect of what amounts toa somewhat reduced version of the Great Depression in the Western world."
Fareed Zakaria: Ken Rogoff, worrying about the wrong thing?
Ken Rogoff: Well, I think the downgrade was well justified. It's a very volatile world. And the reason there's still a demand for treasuries is they've been downgraded a little bit to AA plus. That looks pretty good compared to a lot of the other options right now.
It's a very, very difficult time for investors. There is a financial panic going on at some level. Some of it's adjusting to a lower growth expectations, maybe a third of what we're seeing. Two-thirds of it is the idea no one's home – not in Europe, not in the United States. There's no leadership. And I really think that's what's driving the panic.
Fareed Zakaria: But you wrote in an article of yours that you think that this is part of actually a broader phenomenon which is that people are realizing this is not a classic recession, this is not a classic cyclical downturn. This is what you call a "Great Contraction". Explain what you mean by that.
Ken Rogoff: Well, recessions we have periodically since World War II, but we haven't really had a financial crisis as we're having now. And Carmen Reinhart and I think of this as a great contraction, the second one, the first being the Great Depression, where it's not just unemployment, it's not just output, but it's also credit, housing and a lot of other things which are contracting. These things last much longer because of the debt overhang that we started with. After a typical recession, you come galloping out. Six months after it ended, you're back to where you started. Another six or 12 months, you're back to trend.
If you look at a contraction, one of these post-financial crisis events, it can take up to four or five years just to get back to where you started. So people are talking about a double dip, a second recession. We never left the first one.
Fareed Zakaria: So, Paul Krugman, what the implication of what Ken Rogoff is saying is spending large amounts of money on stimulus programs is not going to be the answer because, until the debt overhang works its way off, you're not going to get back to trend growth. So, in that circumstance, you'll be wasting the money. Is that – is –
Paul Krugman: No, that's not at all what it implies. I think my analytical framework, the way I think about this, is not very different from Ken's. At least I certainly believed from day one of this slump that it was going to be something very different from one of your standard V-shaped, down and up recessions, that it was going to last a long time.
One of the things we can do, at least a partial answer, is in fact to have institutions that are able to issue debt - namely the government - do so and sustain spending and, among other things, by maintaining employment, by maintaining income, you make it easier for the private sector to work down that overhang of debt.
Fareed Zakaria: Ken, are you in favor of a – a second or a significant additional stimulus in the way that I think Paul Krugman is?
Ken Rogoff: No. I think that's where we part ways on this. I think that creates a debt overhang in the terms of future taxes that is not a magic bullet because it's not a typical recession. I do think, if we used our credit to help facilitate one of these plans to bring down the mortgage debt in this targeted way, and it could involve a significant amount - that I would definitely consider. I mean, that's how I would do it.
Now, obviously, things go from bad to worse, then you start taking out more and more things from the toolkit, but I would start with targeting the mortgages, then higher inflation, try to do some structural reforms and, of course, if things are still going badly, I'm open to more ideas.
Paul Krugman: I would say things have already gone from bad to worse. I mean, this is a terrible, terrible situation out there. You know, we talk about it, we look at GDP, whatever. We have nine percent unemployment and, more to the point, we have long-term unemployment at levels not seen since the Great Depression. Just an incredibly large number of people trapped in basically permanent unemployment.
This is something that desperately needs addressing. And I would be saying we should not be trying one tool after another from the toolkit a little bit at a time. At this point, we really want to be throwing everything we can get mobilized at it.
I don't think fiscal stimulus is – is a magic bullet. I'm not sure that inflation is a magic bullet in the sense that it's kind of hard to get, unless you're doing a bunch of other things. So we should be trying all of these things.
How did the Great Depression end? It ended, actually, of course, with World War II, which was a massive fiscal expansion, but also involved a substantial amount of inflation, which eroded the debt. What we need - hopefully we don't need a world war to get there - but we need this kind of all-out effort which we're not going to get.
Fareed Zakaria: You say World War II got us out of the Depression. This was a massive stimulus, massive fiscal expansion. But aren't we in a different world?
We are, right now, the United States with a budget deficit 10 percent of GDP, which is the second highest in the industrial world. In two our debt-to-GDP ratio goes to 100 percent. That strikes me as a situation, which presumably has some upper limit. You can't just keep spending money and incur these larger and larger debt loads.
Paul Krugman: I think those numbers are a bit high, about the debt levels a couple years out. It takes longer than that.
But the main thing to say is, look, think about the costs versus benefits right now. Basically, the U.S. government can borrow money and repay in constant dollars less than it borrowed. Are we really saying that there are no projects that the federal government can undertake that have an even slightly positive rate of return? Especially when you bear in mind that many of the workers and resources that you employ on those projects would be otherwise be unemployed.
The world wants to buy U.S. bonds. Let's supply some more, and let's use those bonds to do something useful which might, among other things, help to get us out of this terrible, terrible slump.
Ken Rogoff: Well, I think you have to be careful about assuming that these low interest rates are going to last indefinitely. They were very low for subprime mortgage borrowers a few years ago. Interest rates can turn like the weather.
But I also question how much just untargeted stimulus would really work. Infrastructure spending, if well spent, that's great. I'm all for that. I'd borrow for that, assuming we're not paying Boston Big Dig kind of prices for the infrastructure.
Fareed Zakaria: But, even if you were, wouldn't John Maynard Keynes say that if you could employ people to dig a ditch and then fill it up again, that's fine. They're being productively employed, they pay taxes, so maybe the Boston's Big Dig was just fine after all?
Paul Krugman: Think about World War II, right? That was actually negative for social product spending, and yet it brought us out. I mean, partly because you want to put these things together, if we say, "Look, we could use some inflation." Ken and I are both saying that, which is of course anathema to a lot of people in Washington, but is in fact what the basic logic says.
It's very hard to get inflation in a depressed economy. But if you have a program of government spending plus an expansionary policy by the Fed, you could get that. So if you think about using all of these things together, you could accomplish a great deal.
If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the space alien threat - and really inflation and budget deficits took secondary place to that - this slump would be over in 18 months. And then if we discovered, oops, we made a mistake there aren't actually any space aliens.
Ken Rogoff: So we need Orson Wells is what you're saying?
Paul Krugman: There was a Twilight Zone episode like this, which scientists fake an alien threat in order to achieve world peace. Well, this time we need it in order to get some fiscal stimulus.
Fareed Zakaria: But Ken wouldn't agree with that, right? The space aliens wouldn't work –
Ken Rogoff: I think it's not so clear that Keynes was right. I mean, there have been decades and decades of debate about whether digging ditches is such a good idea.
And my read of the debate is when the government does really useful things and spends the money in useful ways, it's a good idea. But when it just dig ditches and fills them in, it's not productive and leaves you with debt.
I don't think that's such a no-brainer. There are people going around saying, "Oh, Keynes was right. Everything Keynes said was right." I think this is a different animal, with this debt overhang that you need to think about from the standard Keynesian framework.
Paul Krugman: I guess I just don't agree. I mean, the debt overhang was an issue in the '30s, too - private sector debt overhang. We came into this with higher public debt than I would have liked, right? We're really, in some ways, paying the cost to the Bush tax cuts and the Bush unfunded wars, which leave us with a higher starting point of debt.
But the thing that drives me crazy about this debate, if I can say, is that we have these hypothetical risks. All those hypothetical things are leaving us doing nothing about the actual thing that's happening, which is mass unemployment, mass waste of human resources, mass waste of physical resources.
This is what's happening. We are hemorrhaging economic possibilities and also destroying a lot of lives by letting this thing drift on. And we're inventing these phantom threats (sometimes ghosts are real, I guess) to keep us from acting.
Fareed Zakaria: Do you think that the lesson from history, Ken, in terms of these kind of great contractions - we have not had something like this since the 1930s, but there have been other examples - tells you that until you get these debt levels down, no matter what the government does, it's not going to get you back to robust growth?
Ken Rogoff: I do, because what happens as you're growing slowly, the debt problems start blowing up on you. That's happening very dramatically in Europe. They had a philosophy and approach of things are going to get much better - 'if we can just hang on, we're going to grow really fast, the debt problems will go away.'
Well, guess what? They're not growing fast enough. The debt problems are imploding. That's slowing growth, and it's a self- feeding cycle.
Paul Krugman: I guess I'm a little puzzled here because, again, the thing that's holding us back right now in the United States - although there are those peripheral European countries that are having a very different kind of problem, partly because they don't have their own currencies - but, in the United States, what's holding us back is private sector debt. And, yes, we're not going to have a self sustaining recovery unless that private sector debt could be brought down.
Fareed Zakaria: Just to be clear, Paul, what you mean by that is individuals have a lot of debt on their balance sheets?
Paul Krugman: Yes, that's what's holding us back, and we do need to bring that down - at least bring it down relative to incomes. So what you need to do is you need to have policies to make incomes grow.
That can include government spending, which is going to add to public debt, but it's going to reduce the burden of private debt. It can include inflationary policies, and it can include deliberate forgiveness.
The idea that this has all faded, that we cannot do anything to grow because we have to wait for some natural process to bring that debt down, that doesn't follow from the analysis. There is a huge overhang of debt, which is, at least as I see it, exactly the reason why we need very activist government policies.