How to cure an economic depression

The answer could be to stop the government from intervening and let the existing debt destroy itself.

By , Guest blogger

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    In this March 1932 file photo from the Great Depression, three unemployed men start a fire for cooking in this vacant lot in New York City, where they live when they are not searching for work.
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Paris, France – “As recently as two years ago, anyone predicting the current state of affairs (not only is unemployment disastrously high, but most forecasts say that it will stay very high for years) would have been dismissed as a crazy alarmist.”

That was Paul Krugman in today’s newspaper. Thomas Friedman is fixing problems in the Middle East, so we’ll have to make do with Krugman to entertain us on economic matters.

It is amazing that anyone takes Krugman seriously. It is obvious now that he – and his fellow interventionists – had no idea what was going on two years ago.

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Now, at least he sees the drift of events more clearly; we are headed towards a Japan-style deflationary slump.

“It’s a good bet that by some measures we’ll be seeing deflation by sometime next year,” he writes.

“Mr. Bernanke has thought long and hard about how to avoid a Japanese-style economic trap, and the Fed’s researchers have been obsessed for years with the same question. But here we are, visibly sliding toward deflation…”

So you see, dear reader, even a Nobel Prize-winning dog can learn a new trick. Now, he sees through a glass darkly… Soon, he will be face to face with deflation.

Of course, the poor man still completely misunderstands what is really going on. But what do you expect? His career depends on not understanding it. Krugman would have to turn his back on his neo-Keynesian creed if he ever caught on to the plot. He would have to look for a new job if he were ever to tell his readers about it. Almost everyone wants the feds to “do something” to avoid the Japanese “trap.” Imagine what would happen if The NY Times leading economist were to say:

“Forget it. The feds have already done too much. Following my advice, they were a major cause of the present crisis. Following my advice, they have made it worse. I was wrong. Now the best thing they can do is to withdraw as gracefully as possible.”

That’s not what Times readers want to hear. It’s not what anyone wants to hear, except us “crazy alarmists” here at The Daily Reckoning.

We’ve been talking about the Japan trap for years. Economist Richard Koo calls it a “balance sheet recession.” He’s right about that. The private sector destroys excess capacity and excess debt. When it’s over, the private sector balance sheet looks a lot better.

Of course, it could happen faster. In Japan, it may still be going on. Why? Because the Japanese feds worked so hard to stop it. Monetary stimulus. Fiscal stimulus. Quantitative easing. They tried everything. And kept at it for nearly 20 years.

But what they were really doing was preventing the one fix that really fixes. It is as if they were letting the air out of the market economy’s tires…and then were amazed that it didn’t roll.

You know what cures a depression, dear reader? We’ll tell you. A depression.

A depression destroys excessive debt. Businesses with too much debt go broke. Bonds that can’t be paid go into default. Households that have spent more than they could afford go broke.

Problem solved. Debt disappears.

Then, the economy can grow again.

So what does Krugman suggest? You guessed it: stop the process of debt destruction at all costs! Do what the Japanese did, in other words, only do more of it.

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