How much do monetary and fiscal policy matter?

Paul Krugman:

The truth is that policy should be piling on, not looking for the exit. But central bankers can’t wait to pull away the punchbowl, even though the party hasn’t started, and shows no signs of starting for years to come.

And:

We’ve got the president telling Fox News that he’s worried about a double-dip recession if he doesn’t reduce the deficit soon — as opposed to the concern I and other have that he’ll have a double dip if he doesn’t provide more support.

I’m not sure Krugman is asking the right questions.  The way I see things is this:  If we fix the financial system quickly — use the bankruptcy process to wipe out a lot of real economy debt and deal with the resulting bank failures via a resolution authority and by making sure that the remaining banks are well-capitalized — what Krugman calls a “liquidity trap” will disappear.  Only once consumers and firms feel that they no longer face a crushing debt burden will they be able to participate fully in the economy.

After the bankruptcies and bank closures have taken place, the Fed will no longer need to hold rates at ridiculously low levels to recapitalize the banking system and cause savings to move from Treasuries into CDs.  In this scenario the banking system can lead the recovery and government spending is of only secondary importance to the health of the economy.

On the other hand, if we fix the financial system, the spending that Krugman proposes won’t do any harm either, because we will be able to grow out of our debt.

I’m really just not sure whether or not government spending to support the economy matters very much.  In my view it is far, far, far more important to fix the financial infrastructure — by ending the policy of extend and pretend — so natural economic forces can drive a recovery.

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