Paul Krugman, “The Economic Meltdown: What Have We Learned If Anything?” - MIT Lecture 2/5/2010

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WU: Well, hello, everyone. Thank you for coming. I know it's been hard to get in today.

We want to welcome you to the spring lecturer of the Undergraduate Economics Association. I'm Charles Wu, the president.

PATTY: I'm Manisha Patty. I'm the vice president. Sorry for running in. Let me now present the head of the economics department, Ricardo Caballero, to introduce our distinguished lecturer today.

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CABALLERO: Thank you. And welcome, you all, to this very, very special event put together by Teresa, Sarah, and the Economics Undergrad's Association. It's certainly a great honor to introduce to you Paul Krugman.

Thank you very much, Paul, for being here. We know that your time is quite scare these days. I think the reason, though, he came is because Paul is truly an MIT guy.

He did his PhD here. He has been a member of the faculty more than once. And who knows what the future brings, no? But he clearly is part of our community. And so I thank you very much. You make us very proud, Paul.

Many of you may know Paul for his very insightful and entertaining opinion columns in New York Times and many other venues. Some of us, however, have the privilege of knowing the other part of Paul, his academic side. And I grew up learning from Paul's papers.

And we never had any doubt that he would receive the Nobel Prize. The question was when. And we're delighted that it already happened in 2008. And again, this was the last of a long sequence of all the possible awards you can get in economics.

And it's pretty easy for the insiders, for the economists, to understand why he got these prizes. Not only does he have seminal contributions in international trade and international finance, but also reading an academic paper by Paul, as it is to read in a column actually, it's a delight. Paul has probably the largest ratio of insight to mathematics that you can find in academic papers.

And I think the main reason that's the case is that he has superb economic intuition. Truly outstanding. I would compare it to that of our late and great Paul Samuelson. These are people that can really use math to communicate ideas. But they have seen what they want to say well before they saw the equations. That's pretty unique.

In fact, I'm not sure I should say this, but when I was a student here in our graduate program, we used to joke with some of my classmates that many of Paul's papers had mathematical errors in them. But they always came in pairs. And they offset each other, so the conclusions were always right.

And that's how good his intuition is. In any event, it's a great honor to have you with us, Paul. Welcome.

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KRUGMAN: So Ricardo kind of trumped my response, which was, the real reason that I have such a high ratio of other stuff to math in my papers is, I'm actually a quite lousy mathematician. But OK. So I'm going to try and talk not too long, because my general impression on these things is that the back and forth is a lot more interesting than the lecture.

As the title of the talk implies, I really want to talk some about the state we're in, but also some about the intellectual state we're in. Where are we now? And how could this happen? Have we actually learned anything from it? And so on.

So when I try and think about the mess we're in, I often find myself going back to an incident that happened back in 2002. I wasn't there, but I've read about it. There was a conference at the Federal Reserve to honor Milton Friedman on his 90th birthday.

And at that conference, Ben Bernanke, who had recently moved to the Fed from teaching at some school or other in New Jersey, addressed Milton Friedman and Schwartz in reference to Friedman's famous work on the errors of the Federal Reserve, which, according to Friedman, was the reason that the Great Depression happened. If the Fed had only done its job, it wouldn't have happened.

Ben Bernanke said, on behalf of the Federal Reserve, I'd like to say to you, yes, you're right. We did it. We're very sorry. But thanks to you, it won't happen again.

Six years later, it happened again. And so the question I want to ask is, how is it that we got into something that bears such a distinct resemblance to the Great Depression? What were the mistakes, and what have we learned? Are we actually continuing to make some of the old mistakes?

What's going on here? I guess, at some level, the question is, what are economists good for? But in any case, the question is, how did all this happen?

So let me talk first about what it is we thought we knew. What we thought we knew was that the Great Depression was possible first and foremost because we had an unprotected banking system combined with a Federal Reserve, a monetary authority, that didn't understand what needed to be done. And so there was a recession. There was a stock market boom and bust. And there would have been a recession regardless.

But what made the Great Depression so great was banking collapse. There was a loss of confidence. People pulled money out of the banks. It led to a collapse of the financial system, panic, disruption of markets.

The Federal Reserve failed to act forcefully. It failed to supply liquidity. It failed to rescue banks that were in trouble. It failed to prevent a sharp fall in the money supply.

Although there's a real question, I think, given what's happened right now, whether they really could have. But certainly, the story as Milton Friedman told it was that, if only the Fed had done what it should have, there wouldn't have been a shortfall of money supply and there wouldn't have been a Great Depression. And then, going on from there, the argument is that governments didn't understand what needed to be done. They didn't act on it.

They did some mild what we would now call Keynesian programs. But they were never remotely big enough, as, actually, a former department at MIT, E. Cary Brown, famously showed, that once you adjust for cyclical effects on the budget, there really never was very much fiscal expansion during the '30s. That fiscal policy didn't work because it was never tried.

And to the extent that there was fiscal policy, it was halfhearted. It was pulled back. There was the famous mistake of 1937, when FDR was convinced that the recovery was solid and no longer needed all that support from the government. The Federal Reserve, similarly convinced, tried to mop up some of those excess reserves in the banking system. And the result was a severe recession, the Second Great Depression, as many people called it at the time-- all of these mistakes that came from the past.

And since we knew about all that, it wasn't going to happen again. We had banks which were protected by deposit insurance, so as to rule out bank runs. We had regulation of banks to go along with the insurance. We had monetary authorities who understood the risks and would not make the same mistakes that banks made in the '30s.

Altogether, we had learned the lessons. We were in a position not to make those same mistakes all over again. At the very least, we would understand that you don't allow a plunge in the money supply. So this wasn't supposed to be possible again.

And then came our current crisis. What do we understand now about the crisis? What we understand, I think, is that we ended up having something that was a teched up 21st century version of what happened in 1930, that it was very much a replay of the same kinds of events.

Now, things look different. Because bank deposits are insured, we did not have bank runs in the form of mobs of people out in the street pounding on the doors of closed bank buildings. But we had the economic equivalent of bank runs, with people rushing to pull short-term funds out of institutions that really were not in a position to repay those funds on short notice. So we had a financial collapse. By some measures, the financial disruption that took place in 2008 was as bad as what happened in 1930, 1931.

We had a monstrous bubble in housing and in real estate more generally coming into this, which looked every bit as crazy, in retrospect, as the stock market boom of the '20s. What's really weird is that we managed to have that giant bubble just a couple of years after our own giant stock bubble. But nonetheless, we had that, which depressed the economy and created what would surely have been a serious recession, even if the financial system hadn't gone completely bust-- but on top of that, the major collapse of the financial system.

Well, all in all, it looked a whole lot like the slump in at the beginning of the '30s. You can read John Maynard Keynes's great essay. This is six years before he published "The General Theory of Employment, Interest, and Money." He wrote an essay called "The Great Slump of 1930." And you really only have to change a few words to make it sound like it's a description of recent events.

It was something that was very, very similar in its form, not like the great recessions of '74, '75, or of the early 1980s, which were driven, at least to a large extent, by external events by disruption of oil supply. This was a purely internal malfunction. It was, as Keynes wrote in 1930, magneto trouble, which turns out to be actually-- I thought it was alternator, but it's more like the early version of a spark plug or something. But anyway, a small part in the car malfunctioned but it brought the whole engine to a stop. And we did it all over again.

How is that possible? A part of the answer is that we-- actually, let me say it a little differently. What I say is that we had a combination of mislearning the lessons of the Great Depression, forgetting the lessons, and failing to generalize-- excessive literal-mindedness. So let me go through those in some sequence.

In terms of mislearning, we developed a conviction that the Federal Reserve or its counterparts abroad can always do whatever is necessary to stop a slump. The interpretation, not at the time, but some years later, by the time that Milton Friedman was in his heyday, was that people had become convinced that, if only the Federal Reserve had been more aggressive, that would easily have prevented the Great Depression. And since we had smarter, better central bankers these days, we were never going to experience that again.

Even before this hit, if you were looking at events outside the United States, you realized that that was probably a misinterpretation, that, yes, the Fed can always print lots of money. But if short-term interest rates go to zero, further money printing doesn't do anything. It has no traction.

It's not clear. When Friedman and Schwartz showed that there was a big decline the money supply, they used a broad measure of money, which was a variety of deposits, as well as just currency and bank reserves. And it was just presumed that the Fed could have stopped that from falling. It's not at all clear that it could have.

And we could see that in a way now, where there's vast amounts of bank reserves out there which are not being lent out. And so we probably mislearned some of the lessons of the 1930s. There was an unwarranted belief that it was easy for technical operations by the Federal Reserve to prevent this crisis.

We forgot some of the lessons. I think people simply forgot just how unstable financial markets can be. They forgot how difficult it can be to get policy traction when things are really bad. It's another example of reading old stuff.

You can acquire a newly printed edition of the 1948 edition of Paul Samuelson's economics textbook. And it's really interesting reading. And particularly, if you read the sections about the limits of monetary policy in fighting slumps, it sounds exactly right. It sounds exactly like what we're going through right now.

So Samuelson in 1948 had a really good appreciation of the limits of policy. But we forgot that. By the time I started writing a principles of economics textbook, all of those caveats, all of those cautions were gone, and the general view was of the omnipotence of central banks, at least in their ability to create demand.

And so we forgot lessons. We forgot stuff that we had known. I'll be talking more about that forgetting in a few more minutes.

And literalness-- we did know that banks are subject to bank runs, although we forgot just how serious. There was a big move to deregulate banks, which was based on forgetting just how badly they'd gone awry in the past. But mainly, what happened was-- and I'm guilty of this too-- you looked out there and said, well, but we have deposit insurance. We have guarantees. We have credit lines from the Federal Reserve. Banks can go bad, but we can't have the kinds of destructive bank runs, the kind of disruptive failure of the banking system that we had in the 1930s, because we do have institutions to protect against that.

The trouble was, of course-- now it's "of course--" that we were excessively literal in our idea of what it is to be a bank. We thought of a bank as being, well, basically, a big marble building with a row of tellers and Jimmy Stewart running it, whereas, in fact, of course, we should have known better. Even in your basic economic models of bank runs, the bank that appears in those models is not defined by those characteristics. The bank is defined by borrowing short and lending long, by creating liquid assets that people can regard as money, while, at the same time, using the money placed in their care to make investments that can't be turned into cash on short notice.

And by that standard, lots of things are banks. These days now, everybody talks about the shadow banking system, all of the institutions that were effectively banks but were not-- depository institutions. Until the crisis hit, no one was thinking much about that. And so we were caught by surprise.

It turned out that you could have bank runs just like the old ones except not quite so visible because we had all of these things that were banks, but not banks in the old sense, and subject to the same kind of collapse of confidence. So instead of mobs of people in the street, you had mobs of investors refusing to roll over their repos. But the effects were the same. And so we were caught by surprise by this terrifying crisis.

The actual slump has not been as bad as the Great Depression. And there's been some self-congratulation about that, probably excessive. I'm not sure.

I have extremely high regard for my former department chairman. But I'm not sure that "the world didn't end on his watch" is a good enough reason to make Ben Bernanke man of the year. But things have been not as bad as they were in the Great Depression.

And that is an achievement. If we look at the first year, globally, of the slump, it actually was comparable to the Great Depression. Industrial production in the first 12 months will tell us as much this time around as it did from '29 to '30. World Trade fell faster than it did in the first year of the Great Depression, but then it did level off. So what it looks like is that the shock to the system was every bit as bad as it was in the Great Depression, but the system handled it better this time around.

Why was that? Well, part of the answer was, we have learned some things, although there were some obvious failures to understand the depth of the problem. The failure to rescue Lehman was obviously a huge misjudgment, sort of the 21st century equivalent of the failure to rescue the Bank of the United States in 1930.

Nonetheless, there was willingness to step in and rescue key financial institutions. People stepped in to protect the system from a total meltdown. And that certainly helped.

I suspect that a very large part of the reason we didn't have a full replay of the Great Depression, though, is actually not that. Although I wouldn't want to try the experiment of letting more financial institutions go back and do it again and let even more stuff fail and not bail out AIG and all that. Probably a very large part of what went right, or at least didn't go as wrong as it might have this time, was simply the fact that we have much bigger governments than we did 80 years ago. That's an underappreciated aspect of the story.

Big government in the crisis has been a help almost independent of what the governments do, because at least they're there, so that when production is falling, and private sector employment is falling, and people are nervous, and nobody wants to spend, the social security checks are still going out Medicare is still paying the health care bills. There's just a large automatic stabilizer role of government, which has almost surely been a major factor in cushioning the crisis. If we hadn't had that, it could quite easily have been a much, much deeper slump.

And then there have been some deliberate government efforts to prop up demand. Yes, we have a stimulus. Yes, we would probably have 12% unemployment now if we hadn't had the stimulus in the United States. But the efforts to prop up demand have been, on the whole, probably a smaller factor in what's gone right than the simple existence of big government and the moves to stabilize the financial sector.

Still, I don't think you should want to view this as a success story, even so far. What we did was, despite everything we were supposed to have learned, we managed to do something that was at least a pretty significant echo of the Great Depression. Maybe it wasn't the same total collapse. Unemployment wasn't quite so bad.

I was about to say there aren't people selling apples on the street. But actually, there are a lot of people selling whatever on the street. I don't, obviously, personally, have any memories of New York in the '30s. But in New York in early 2010 looks pretty bad. It's been a quite serious devastation to the economy. It's not supposed to have happened.

Furthermore, this thing ain't over. One of the difficult things, I think, that people have in wrapping their minds around is that the end of a recession is not the end of the slump, that, while it's almost certainly true that the National Bureau of Economic Research will eventually declare that the recession ended in June or July of 2009, unemployment has continued to rise-- yes, it was down slightly this morning, but that's statistical noise, almost surely-- and that most of us do not think that it's going to come down quickly at all, that we're likely to be facing probably years of high unemployment, which is years of huge suffering in the population, years that will leave really long-term scars on our society.

The line I was about to use-- well, I'll use it-- is the worst hit, probably, in terms of lifetime impact, are young people graduating from college facing a terrible job market. And what the statistical estimates show is that, basically, if you graduate into a bad job market, you will still be worse off than if you graduate into a good job market even 20 years later. So there will be really long-term damage from all of this. Sorry about that, guys. So everyone leave the room and go polish up your resumes.

Something else is happening again too. I think we're now past the point of saying, oh, my god, how did we manage to reproduce the situation that led to the great crash of 1930? But ever since the GDP seemed to stabilize, the economy seemed to end its freefall.

Now, everyone has been saying, well, the thing now is to make sure we don't repeat the mistakes that were made later during the Great Depression. Don't repeat the mistake of pulling out the support from the economy when the recovery really wasn't solidly in place and sending the economy into a second slump. So we're not going to do 1937 again.

Everyone says that, lots of people on the outside. Christy Romer, the head of the Council of Economic Advisors, has even published an article, "The Lessons of 1937," explaining why we really don't want to do that. The fact is, at least at the moment, it appears that we are going to do that. It's almost baked in at this point.

The stimulus reaches its peak impact on the economy, as best we can tell, this summer, and then starts to fade out. All indications are that unemployment will remain very high. The economy is going to be still deep in the hole.

The Federal Reserve is going to come to an end of its mortgage purchase program, which is one of the main things that it's been doing beyond just keeping interest rates low. Again, that's going to happen in a few months. The economy is still deep in the hole.

If you look at the budget that the administration offered last wee-- this week-- I'm losing my track of time. Anyway, when you look at the budget, it actually predicts or calls for substantial cutbacks in government spending, mainly as a result of the expiration of the fading out of the stimulus, but also because there's now to be a freeze on nonsecurity discretionary spending, which is to appease the deficit hawks. All of that adds up to a pretty significant turn towards contractionary policy taking place over the next year or so in the face of a deeply depressed economy.

Will that actually send us into a double dip recession? I think the technical answer is, God knows. There's so much going on in the economy, it's never possible to really know. But we do know, anyway, that policy is acting as if the problem has been just about solved, whereas the reality is, mass unemployment is a likely feature of the economy for quite some time to come.

What I think we really failed to learn, or certainly, at least in policy, we're not responding to, is that, historically, the aftermath of financial crises is a very, very prolonged period of high unemployment, that it's not something you solve just by stepping in and preventing the freefall of the economy. It's something that is going to require a lot of action to support the economy for an extended period.

Anybody who is interested in these things should look at the work of Carmen Reinhart and Ken Rogoff, who have studied past financial crises and produced summary statistics. What Rogoff says is that we are actually experiencing a garden variety severe financial crisis, which sounds oxymoronic. But what he means by that is that the United States is more or less so far tracking right down the average.

Take a severe financial crisis. The United States is looking just like the average. And in the average financial crisis, unemployment rises for almost five years before it starts turning down. So we are looking at a really prolonged period of high unemployment if history is any guide. And yet we are actually starting to withdraw policy support from the economy quite soon.

So what's going on? How can we be replaying the past so badly. That's really the question that has worried me a lot.

Part of the answer is politics. Obviously, I think we've all learned a pretty harsh lesson in all of this. We've learned that, if you're an economist, you tend to say, well, let's figure out what the optimal policy is, and the job is done once you've explained what that is.

In reality, of course, things have to go through a legislative process. It can be very difficult to do things, even if you're quite sure they should be done, because other people don't agree, or other people actually even might privately believe they should be done, but not with the other guy sitting in the White House. So there's a real difficulty in getting things through.

There's a lot of difficulty also in getting what you do understand economically past even sympathetic politicians. A year ago, there was always a lot of discussion, discussion among the people who were actually going to make the policy bill-- so discussion kibitzing from the outside and some meetings and phone conversations and so on. The political people, who know their job, who think they know what they can get through Congress and so on, tend to always look for partway.

They tend to look for, if you say we need to do this big thing, well, that's hard. Let's do part of it. Their instinct is always to do, well, part of what the economists think ought to be done.

It's very difficult to deal with a situation where actually half a loaf may be not much better than none. And that is kind of the situation when you're faced with this kind of crisis. Because if you do a halfhearted policy, although, economically, it may help, if the economy still looks lousy after you've done the halfhearted policy, the conclusion of the political process is not, well, we need to do more of it. The conclusion is, well, that policy failed, so we can't do anymore.

And so that's been very much the case in the stimulus. I can give you chapter and verse on why the economy would be in much worse shape if the stimulus hadn't been carried out. But the fact that unemployment is still close to 10% means that, in Washington, the view is, well, we've just proved that stimulus doesn't work. And that was somewhat foreseeable, but it was impossible to get that across to the political people, that doing what you think of as a more careful, cautious policy is actually extremely risky, because you really have one shot at this and no more.

Last but not least, the economists themselves are confused. A lot of people probably read the piece I wrote for the Times Magazine. It had been really amazing within the economics profession to see how much has been lost, not by everybody, of course.

But I've used the phrase that we're living in a Dark Age of macroeconomics. And what I mean by that is that there's a difference between the Dark Age and barbarism. Barbarism was, they never knew better. Dark Age is, the people forgot what the Greeks and the Romans knew.

And to some extent, that's where we are in economics now. It's been really astonishing to watch economists reinventing 1930 vintage fallacies as if they were fresh insights, because they don't know about this. There are real disputes you can argue. There are respectable arguments that we should not have done a fiscal stimulus, or that we should have done something very different from what Obama did.

But many of the arguments against stimulus are simple failure to understand very basic insights that were hard-won, but hard-won 70 years ago and, unfortunately, have been lost in the interim. So we came into this deeply unprepared. What happens now?

I don't know. I'm actually really worried about where we are now. If you want to look at the situation, the first year of crisis, we're at just like what Keynes described in "The Great Slump of 1930." So we managed to replicate the crisis amazingly.

When Keynes wrote his, again, masterwork, "The General Theory of Employment, Interest, and Money," it was not during the acute phase of crisis. It was not when the economy was slumping. It was actually written at a time when there had been a significant but incomplete recovery.

And what he was worried about then was not so much, why does the economy fall off the edge? In fact, one of his great strategic decisions was, I'm not going to explain why depressions happen. I'm going to try to explain why they continue, why the economy can remain stuck in a period of high unemployment for many years on end.

That's the world we're in right now. We're in a world where, at the moment, it's hard to see any drivers for a really vigorous recovery. If you ask yourself what's going to happen, something might come along, but consumers are heavily indebted.

Firms are in much better shape. Corporations are in much better shape. But they have lots of excess capacity. Why would they invest?

Where is the demand going to come from? Well, it could come from governments. But politically, we're actually kind of stalled. There is no sentiment.

Instead, there's a great deal of worry about deficits and a lot of pressure to cut spending, not increase it. So we are somewhat caught in a situation that is more than a little bit reminiscent not of the onset of the Great Depression, but the mid-1930s, where you were really stuck in a holding pattern with mass unemployment just becoming a fact of life. I'd like to say that everybody is really rethinking their positions in this environment. There's not much sign of that.

What actually seems to be happening, as far as I can make out, is that, by avoiding utter disaster, we've actually also managed to avoid being forced to confront our own intellectual failings. I would not believe this a year ago, but when I look at the state of discussion, both in Washington and within the economics profession, what is amazing to me is, much of it is as if it were still 2007. And we've gone back to it.

People are espousing the same positions. People are saying the same things, the same rhetoric about private sector, dynamism, and the evils of big government. The same denunciations of Keynesian economics are right back in vogue. Nothing much has changed.

And there doesn't seem to be an obvious forcing event that will change either the economy or the intellectual climate. Something will eventually come along. In the long run, we will work this out, and we'll find a way to recovery.

But you know how this is going to end. John Maynard Keynes is my great idol in economics. And what he said about the long run is, in the long run, we are all dead.

And I left a little thing on my notes here saying, come up with something optimistic to say at the end. But I haven't managed to find it. So with that, I'm going to throw it up for Q&A. Thank you.

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WU: So thank you very much, Professor Krugman, for a wonderful talk. Another round of applause for him.

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PATTY: We have a small gift for Professor Krugman. It is our t-shirt that we sell for UEA. And we would like you to have it--

KRUGMAN: Thank you.

PATTY: --to remember us by.

KRUGMAN: Thank you.

WU: And Professor Krugman has agreed to a few questions from the floor. So please raise your hands and speak clearly. OK, Yeah.

AUDIENCE: Hi. What are the strengths and weaknesses of the fractional reserve system? And do you see value in any of the alternatives to it?

KRUGMAN: OK. The question was, what do I think of the fractional reserve system, and are there any alternatives, which means we have banks that accept deposits and lend out most of the money, but only part of it in the form of liquid reserves. And there have been many people, over the centuries, who have argued that that's a bad thing, and that, basically, banks should be safes, depositories for cash.

You cannot do away with that system. Remember everything I just said. We don't get to define legally what is a bank.

We get to define legally what's going to have deposit insurance. We get to define legally who obeys what regulations. But if you say that banks and depository institutions are not going to be allowed to do anything really with your money, then what will happen is that more and more resources will flow to other institutions that give you ready access to your money, but actually put it to work.

So actually, it's something like fractional reserve. Banking is going to emerge whether you like it or not. So you can't really ban that.

What you can do is, you can try to make sure that at least most of the people who are doing bank type activities are caught within a-- are both circumscribed in what they do and have guarantees behind them. So the trick is not to say that we're going to make-- we're going to go to 100% reserve banking, because if you do that, what we'll do is you create a perfectly safe banking sector, which is totally irrelevant to the economy. And meanwhile, the real banking sector will be subject to all the crises as before.

What you can do instead is to try and make sure that the actual financial system you have has got limits on leverage, capital requirements, guarantees, a resolution procedure, prudential requirements. Basically, what we need to do is, we need to recreate a 21st century version of the '30s, of the New Deal banking reforms, which, we should remember, produced half a century without major financial crises. So it's not that we don't know how to do this. It's just that we don't want to do it, or at least that there's an awful lot of money and ideology standing in the way of doing it. Yeah.

AUDIENCE: What do you think about the idea that China and the United States could determine the economy for the 21st century? And the question is how that [INAUDIBLE].

KRUGMAN: I guess the question was, what do I think about China and the United States determining the economy of the 21st century? There are other people out there, I guess, is the answer. Europe is essentially coequal with the United States as a player, for good and for real.

When they do well, it's good for the world. World trade policy, which is my original home field, is set in Brussels and Washington, not in Washington. Brussels is every bit as powerful in those issues as we are.

India is an increasingly large player. Japan is not negligible, even now. And so no, I don't think that's the way.

Now, we have a big problem, which is that China has become a major economic power while still being quite poor, and also while not actually operating the same way as the others do. Let me put it that way.

Every two years, the Treasury Department is obliged to report on whether China is middling its currency. And every two years, the Treasury lies, because of course they are. And no, they had reasons why they thought it was a good idea. But it becomes a real problem now, especially in this kind of world.

We are in a depressed world, where the normal policies have lost traction, which means that, if one country pursues that undervalued exchange rate and runs an artificial trade surplus, that really is a predatory policy against the rest of the world. So that's the issues that are coming up.

And then, of course, environment-- so China is now number one on least one thing, which is greenhouse gas emissions. So we're going to have to find a way to work out a system. All of our setup, all of our institutions, are still really designed for a world in which a handful of rich countries dominate the world economy. And we haven't yet figured out a way to deal with big but poor economies. Yeah, up there. Yeah.

AUDIENCE: What are your thoughts on the future of the euro with the huge debt prices and Spain and Portugal's economic woes?

KRUGMAN: All right, future of the euro. It's funny. When I was thinking about the last few days, I'm very fond of speaking to eurocrats, to people who work for the European Commission. Because they're actually kind of fun once you learn how to do the talk.

They're very smart, but they're also straight out of "Yes Minister." And they talk in these certain locutions which need to be translated. So the other parallel I use is that I always think it's like the scene in Annie Hall, where they're having a conversation in English, but there are subtitles with what they're really saying.

And so I remember that, back in the early '90s, I'd have conversation with eurocrats. And they would say these elegantly incomprehensible things about widening versus deepening and priorities. And you finally realized that the subtitle actually read, we should never have let the Greeks in.

So what I think about Greece is that that's actually a case of hard cases making bad law. Greece actually has been fiscally responsible from time immemorial. It's been in default half the time every other year since independence.

So Greece was sort of bound to be an accident. And that's not really the revealing case, although now there's some contagion from Greece. The real story and the reason that you need to be worried about the euro is Spain.

Spain actually behaved quite responsibly. Just a couple of years ago, they had a budget surplus. They had relatively low government debt as a share of GDP.

They did all the things you're supposed to do. But they had enormous real estate boom. It's not actually clear what they could have done about that, even if they had chosen to. But anyway, all the respectable people were telling them that there was no problem.

And then when the boom went bust, they have no adjustment mechanism available. They really need to have their manufacturing become much more competitive, compared with Germany and France. But they can't devalue their currency, because they don't have one.

Alternatively, they could get some relief if there was a lot of out-migration of labor, as happens when individual US states are depressed. But of course, although there's legally free movement of labor within Europe, in practical terms, it's not that big. So what's happening to Spain, which now has a massive budget deficit, but only because of the depressed economy, is exactly what euro skeptics-- people who were not sure that Europe was ready for a single currency-- said would happen.

And that is a huge problem. We're having exactly the nightmare scenario, the asymmetric shock to a major eurozone economy with no adjustment mechanism available. It's not how it's going to work. No fiscal integration.

When Florida has a terrible slump, the budgetary consequences, while terrible, are not as bad as they might have been, because the Social Security and Medicare checks come from Washington. Spanish social insurance checks don't come from Brussels. So everything that you worried about that might go wrong from this project of a single currency is going wrong for Spain.

Now, what that means about the future of the euro, I don't know. Because it is a pretty good example of why maybe they should have had some second thoughts about the whole project. But dropping out of the euro is almost infeasible. It's not clear how anyone could do that.

The last time we've seen a major single currency area break up, as far as I know-- Peter may know better, [MUTTERING]-- but I think it's the breakup of the Austro-Hungarian Empire at the end of World War I. And that was done by-- they closed the borders for several weeks while all the currency was exchanged and the banks' deposits were converted. And I don't think you can do that in the modern world.

So we really have a very ugly problem. My guess is that there might be some at least limited defaults by some eurozone governments. It probably doesn't bring down the euro. The zone probably doesn't break up, because it's very hard see how it can. But this is ugly. This is what we were afraid of.

And I really feel sorry for Spain, which really, again, played by all the rules, and then just got sideswiped by the combination of a huge bubble and the structural problems of the single currency. Yeah. Yeah.

AUDIENCE: So many students here and many of whom will be graduating will get a job and, hopefully, we save money for retirement, since that's what my parents helped me realize. So with the lack of regulation that is here now and, if, let's say, the administration and the economy doesn't pack regulations but it kills it, there might be more of a boom and bust cycle. So what do you recommend for next year's student?

KRUGMAN: Oh, gosh. I really hate doing investment advice. I have to say, even with all of that, it's a little early.

When I got my first job, I got this gold-embossed envelope on creamy paper. I thought, oh, here's the actual contract. And it turned out to be my retirement plan.

And I was 24 years old. And really, it's too soon to be thinking about retirement. Think about it later. Not too much later, but not at that age.

AUDIENCE: So these firms that still got a lot of money, but they don't invest it, shouldn't we split up these firms? Also, in the long run, the government can be hijacked again by "too big to fail."

KRUGMAN: Oh, OK.

AUDIENCE: How likely is it that that's going to happen?

KRUGMAN: OK, the question is, should we be breaking up "too big to fail" financial firms? Is it going to happen? I don't have any problem with breaking up big financial institutions. I think it's not all clear that there is any big benefit from having them.

I don't believe that they're at the essence of the financial crisis. And there are several layers on that. One is that, even analytically, our basic understanding of how it is when you have a financial crisis, how you can have bank runs, does not hinge on there being big players. You can have bank runs even if there are many, many small banks, which is more or less what happened in the 1930s.

So there's nothing to prevent that from happening. Breaking up "too big to fail" does not insulate you from the chance of a financial crisis. Conversely, having banks that are too big to fail is no guarantee that you will be in trouble.

So we can make that argument various ways. But the easiest one, maybe, is to just say, look, the stellar example right now is Canada, which is really kind of amazing. We should be looking to the great moral and intellectual leadership from Canada.

I discovered this Monday. I guess because there is more and more Canadian stuff, for some reason, appearing, the Times has introduced a new style rule, which is that we are not, in fact, allowed to make fun of the way Canadians end their sentences, eh. But anyways, Canada basically has five banks. Those five banks dominate the scene, which means that, from the point of view of the Canadian system, all of their banks are too big to fail. And that was not at the core of the problem.

If I were going to make a strong argument for breaking up big banks, it would be that the big banks have too much political influence, that they're too big to constrain politically, that they end up being able to write legislation on their own behalf, which is pretty much what happened, more or less. Sandy Weill decreed the end of Glass-Steagall. And the legislative process was just a formality. So that's an issue, although even small banks, through their trade associations, can do a lot of damage.

But if I had to make a choice between getting Paul Volcker's limitations on big banks or Elizabeth Warren's choice of a proposal for a Consumer Financial Protection Agency, I would take Warren's agency in a second. I think it's much more important to act on protecting consumers from predatory or confusing lending. It's more important to have capital requirements.

I actually think that the bill that the House passed, the Barney Frank bill basically, which addresses these things, but doesn't really address too big to fail, is a really good piece of legislation. And I wish there was some chance it would actually get through the Senate. So it's not an irrelevant issue, but it's not the core of the problem.

AUDIENCE: What about the companies like GM or--

KRUGMAN: Oh, big companies. GM or C-- again, the size, that has not really turned out to be a problem here. I mean, antitrust, yes, and you want market power.

One of the good things that's happening behind the scenes is that antitrust enforcement seems to actually be coming back now. But that's not at the core of the macro problems. OK, go. Yeah.

AUDIENCE: So if one of your main question be how could this happen again, isn't it just as possible that maybe because the economy is cyclic, maybe it was a mischaracterization to say that we foolproofed the economy such that it never happens again?

KRUGMAN: So the question is, wasn't it just a mistake to think that we could set up a system so that these things wouldn't happen again to the economy? The way I look at, actually, is that we went 50 years without a big crisis. And we really only started on the route to this crisis when we politically and intellectually started to forget about the old lessons.

As long as banks were pretty heavily regulated, as long as there was a sort of proper suspicion of too much creativity in finance, we were relatively safe from these things. Now, it may be that there is a kind of a larger logic that says that these things will happen eventually.

So people are rediscovering Hyman Minsky, a heterodox economist. The Minsky argument is that there is a cycle in these things, that after crises, people become very cautious, both in the private sector and public policy. And then that produces an extended period of stability. And then people forget about the risks in something. And then they revert to all the bad old behaviors.