Greg Mankiw interview on policy alternatives:

(source: CNBC, click to play)

Paul Krugman on NBER’s recession call and his assessment on the current state of the economy (source: CNBC)

Also, in reply to the criticism that big government spending will increase budget deficits and crowd out private investment, he elaborates his views on NY Times of why big government spending is needed now, budget deficits shouldn’t be the main worry, and government spending won’t crowd out private investment.

Deficits and the Future

Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall. Others, however, worry about the burden that large budget deficits will place on future generations.

But the deficit worriers have it all wrong. Under current conditions, there’s no trade-off between what’s good in the short run and what’s good for the long run; strong fiscal expansion would actually enhance the economy’s long-run prospects.

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that this in turn reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.

But circumstances right now are anything but normal. Consider what would happen next year if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans.

Would this lead to lower interest rates? It certainly wouldn’t lead to a reduction in short-term interest rates, which are more or less controlled by the Federal Reserve. The Fed is already keeping those rates as low as it can — virtually at zero — and won’t change that policy unless it sees signs that the economy is threatening to overheat. And that doesn’t seem like a realistic prospect any time soon.

What about longer-term rates? These rates, which are already at a half-century low, mainly reflect expected future short-term rates. Fiscal austerity could push them even lower — but only by creating expectations that the economy would remain deeply depressed for a long time, which would reduce, not increase, private investment.

The idea that tight fiscal policy when the economy is depressed actually reduces private investment isn’t just a hypothetical argument: it’s exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

The second episode took place 60 years later, in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.

Just to be clear, I’m not arguing that trying to reduce the budget deficit is always bad for private investment. You can make a reasonable case that Bill Clinton’s fiscal restraint in the 1990s helped fuel the great U.S. investment boom of that decade, which in turn helped cause a resurgence in productivity growth.

What made fiscal austerity such a bad idea both in Roosevelt’s America and in 1990s Japan were special circumstances: in both cases the government pulled back in the face of a liquidity trap, a situation in which the monetary authority had cut interest rates as far as it could, yet the economy was still operating far below capacity.

And we’re in the same kind of trap today — which is why deficit worries are misplaced.

One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run.

Should the government have a permanent policy of running large budget deficits? Of course not. Although public debt isn’t as bad a thing as many people believe — it’s basically money we owe to ourselves — in the long run the government, like private individuals, has to match its spending to its income.

But right now we have a fundamental shortfall in private spending: consumers are rediscovering the virtues of saving at the same moment that businesses, burned by past excesses and hamstrung by the troubles of the financial system, are cutting back on investment. That gap will eventually close, but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more.

The bottom line, then, is that people who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action, both for today’s workers and for their children, is to do whatever it takes to get this economy on the road to recovery.

Whitney’s interview today on CNBC:

(click to play)

And her op-ed piece on FT, “America must keep consumer liquidity flowing“.

Facing sharp fall of its export in coming quarters, Chinese government seems to reverse its course of letting Yuan appreciate against the US dollar (source: FT).

While Chinese and Indians are flooding into much more expensive American universities, more Americans are going to universities overseas for their cheaper tuition.  Not only for a study-abroad semester, but for the entire degree.  One of their favorite destinations: Scotland. (source: NYT)

Official recession watchers at the NBER said today that the U.S. is recession, and it began in December 2007. Here is the text of their statement.

The Business Cycle Dating Committee of the National Bureau of Economic Research met by conference call on Friday, November 28. The committee maintains a chronology of the beginning and ending dates (months and quarters) of U.S. recessions. The committee determined that a peak in economic activity occurred in the U.S. economy in December 2007. The peak marks the end of the expansion that began in November 2001 and the beginning of a recession. The expansion lasted 73 months; the previous expansion of the 1990s lasted 120 months.

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion.

Greg Mankiw explains Keynesian policy prescriptions in current situation — Government now becomes the last resort to generate aggregate demand, but he is worried about the long-term impact of budget deficits; The Fed should have a bigger role to play and it has some secret weapons.  This is a must-read.

IF you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

The economy's output of goods and services is traditionally divided into four components: consumption, investment, net exports and government purchases. Any expansion in demand has to come from one of these four. But in each case, strong forces are working to keep spending down.

CONSUMPTION The Conference Board reports that consumer confidence is near its record low. It is easy to understand why consumers are so scared. House values have declined, 401(k) balances have shrunk and unemployment is up. For many people, the sense of economic uncertainty is greater than they've ever experienced. When it comes to discretionary purchases, like a new home, a car, or a washing machine, wait-and-see is the most rational course.

A bit more saving is not entirely unwelcome. Many economists have long lamented the United States saving rate, which is low by international and historical standards.

For the overall economy, however, a recession is not the best time for households to start saving. Keynesian theory suggests a "paradox of thrift." If all households try to save more, a short-run result could be lower aggregate demand and thus lower national income. Reduced incomes, in turn, could prevent households from reaching their new saving goals.

INVESTMENT In normal times, a fall in consumption could be met by an increase in investment, which includes spending by businesses on plant and equipment and by households on new homes. But several factors are keeping investment spending at bay.

The most obvious is the state of the housing market. Over the past three years, residential investment has fallen 42 percent. With house prices continuing to decline, increased building of new homes is not likely to be a source of robust demand over the next few years.

Business investment has lately been stronger than residential investment, but it is unlikely to pick up the slack in the near future. With the stock market down, interest rates on corporate bonds up and the banking system teetering on the edge, financing new business projects will not be easy.

NET EXPORTS Not long ago, it looked as if the rest of the world would save the United States economy from a deep downturn. From March 2004 to March 2008, the dollar fell 19 percent against an average of other major currencies. By increasing the price of foreign goods in the United States and reducing the price of American goods abroad, this depreciation discouraged imports and bolstered exports. Over the last three years, real net exports have increased by about $250 billion.

In the coming months, however, the situation may well go into reverse. As the United States financial crisis has spread to the rest of the world, fast-moving international capital has been looking for a safe haven. Ironically, that haven is the United States. Since March, the dollar has appreciated 19 percent, a move that will put a crimp in the export boom.

GOVERNMENT PURCHASES That leaves the government as the demander of last resort. Calls for increased infrastructure spending fit well with Keynesian theory. In principle, every dollar spent by the government could cause national income to increase by more than a dollar if it leads to a more vibrant economy and stimulates spending by consumers and companies. By all reports, that is precisely the plan that the incoming Obama administration has in mind.

The fly in the ointment — or perhaps it is more an elephant — is the long-term fiscal picture. Increased government spending may be a good short-run fix, but it would add to the budget deficit. The baby boomers are now starting to retire and claim Social Security and Medicare benefits. Any increase in the national debt will make fulfilling those unfunded promises harder in coming years.

Keynesian economists often dismiss these long-run concerns when the economy has short-run problems. "In the long run we are all dead," Keynes famously quipped.

The longer-term problem we now face, however, may be more serious than any that Keynes ever envisioned. Passing a larger national debt to the next generation may look attractive to those without children. (Keynes himself was childless.) But the rest of us cannot feel much comfort knowing that, in the long run, when we are dead, our children and grandchildren will be dealing with our fiscal legacy.

So what is to be done? Many economists still hope the Federal Reserve will save the day.

In normal times, the Fed can bolster aggregate demand by reducing interest rates. Lower interest rates encourage households and companies to borrow and spend. They also bolster equity values and, by encouraging international capital to look elsewhere, reduce the value of the dollar in foreign-exchange markets. Spending on consumption, investment and net exports all increase.

But these are not normal times. The Fed has already cut the federal funds rate to 1 percent, close to its lower bound of zero. Some fear that our central bank is almost out of ammunition.

Fortunately, the Fed has a few secret weapons. It can set a target for longer-term interest rates. It can commit itself to keeping interest rates low for a sustained period. Most important, it can try to manage expectations and assure markets that it will do whatever it takes to avoid prolonged deflation. The Fed's decision last week to start buying mortgage debt shows its willingness to act creatively.

It is hard to say how successful monetary and fiscal policy will be in avoiding a deep downturn. But as events unfold, you can be sure that policymakers in the Fed and Treasury will be looking at them through a Keynesian lens.

In 1936, Keynes wrote, "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist." In 2008, no defunct economist is more prominent than Keynes himself.

Take a deep look at Obama's economic policy from the viewpoints of his chief economic adviser: Larry Summers. (source: NYT)