Krugman Proves Keynesianism Isn't Dead After All: William Pesek

Commentary by William Pesek

Oct. 20 (Bloomberg) -- It's hard to forget the first time I met Paul Krugman. It was in the men's room.

It was in Singapore in August 1998 and I found myself washing my hands next to the economist -- or at least trying to. As we chatted briefly about the speech he had just delivered on the ``liquidity trap'' undermining Japan, we realized the sinks in the lavatory were broken.

``That's the trouble with liquidity problems,'' Krugman deadpanned. ``They tend to follow you around the world.''

The reason Krugman's joke comes back to me has less to do with him winning the Nobel Prize in economics than the situation in which the global financial system finds itself. The question is whether central banks will lose their ability to control credit and, ultimately, economies.

Krugman, 55, didn't get the Nobel for his work on Japan's lost decade, but for ``analysis of trade patterns and locations of economic activity.'' The Princeton University professor and New York Times columnist is among President George W. Bush's most prominent critics. Coming less than a month before an election, the award left some economists wondering if the Nobel committee was playing politics.

Alan Greenspan also can't be happy. Krugman's columns often connect the dots between the former Federal Reserve chairman's free-market policies and the credit crisis. Greenspan's stock as a guru is falling as fast as Krugman's is rising.

Monetary Paralysis

Krugman's work is getting considerable attention in Asia, and for good reason. His reputation in this region was made in the mid-1990s when he was among the most consistent predictors of the 1997 Asian crisis. A couple of years later, Krugman correctly opined that Asia would stage an impressive comeback.

The economist's research on Japan's monetary paralysis could prove equally prescient in Asia and beyond.

In July, this column explored the risk that lost decades may become the global rule, not the exception. Considering how much worse the crisis has gotten since then, it's becoming harder and harder to dismiss such an outlook.

Since January, the Fed has cut its key interest rate from 4.25 percent to 1.50 percent. Has it helped the U.S. economy?

While there's a considerable lag between central-bank moves and their effect on the economy, U.S. consumers haven't yet begun to feel the full fallout from the credit crisis. Fed Chairman Ben Bernanke will be under pressure to push rates even lower.

Turning Japanese

``For all practical purposes, we're in liquidity trap territory,'' Krugman told Bloomberg's Tom Keene on Oct. 6. ``Bernanke can cut rates some more, but it's not going to have any impact on the real economy. So yes, traditional, conventional monetary policy is out of room. No more bullets.'' America, Krugman added, ``has turned Japanese.''

Added Jon Corzine, the New Jersey governor and former chairman of Goldman, Sachs & Co., in an Oct. 12 interview with NBC: ``What is maybe most important, we need a real economic stimulus. We're in what you call a liquidity trap.''

Krugman did as much as anyone to popularize the phrase generally thought to be coined by John Maynard Keynes. The Nobel committee honoring Krugman at this point in time seems part of a growing realization that Keynesianism, with its emphasis on the government's role in the economy, isn't dead after all.

`Comrade Bush'

Far from it. At the rate the U.S. is socializing its financial system, it seems only a matter of time before airlines, automakers and major retailers find their way onto the government's balance sheet. It would be the ultimate irony if the U.S. had to bail out Wal-Mart Stores Inc. with borrowed Chinese money so that it can support all those Chinese factory workers.

Globalization is bringing the world full circle -- from state-owned companies to privatization to the re-nationalization of those enterprises. It's no wonder Venezuelan President Hugo Chavez is referring to the U.S. leader as ``Comrade Bush'' and saying ``now Bush is to the left of even me.''

While that's an overstatement, the policies long advocated by Keynes, and more recently by Krugman, will have more sway than those of laissez-faire capitalism enthusiast Milton Friedman. You can bet worsening market turmoil will prompt Asian governments to follow the U.S.'s lead on public bailouts.

Among the biggest risks is central-bank impotence. As Neil Mellor, London-based currency strategist at Bank of New York Mellon Corp., points out, the mere fact investors are talking about liquidity traps could feed a ``self-perpetuating gloom.'' Keynes, after all, spoke of the mysterious role of ``animal spirits'' in economies.

It was in a similar vein that in 1998 Krugman published his widely circulated paper on Japan's liquidity woes. Krugman speaks of the forces haunting Asia's biggest economy as if they were ghosts in an otherwise functioning machine.

Japan's credit system remains more trapped than free. It's a reminder things could get worse if other nations turn Japanese.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: William Pesek in Tokyo at wpesek@bloomberg.net