Krugman lays it out

Nobel winner Paul Krugman explains what's going on...

The long-feared capitulation of American consumers has arrived. According to Thursday’s G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent.

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It’s true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent — sometimes it has even been negative — and consumer debt has risen to 98 percent of G.D.P., twice its level a quarter-century ago.

Some economists told us not to worry because Americans were offsetting their growing debt with the ever-rising values of their homes and stock portfolios. Somehow, though, we’re not hearing that argument much lately.

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine’s plea: “Grant me chastity and continence, but not yet.” For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.

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For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It’s true that Ben Bernanke hasn’t yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it’s hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.

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No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

Let’s hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let’s also hope that the lame-duck Bush administration doesn’t get in the way.

And read lolDavid Brooks for Krugman's companion piece.

Enjoy your schadenfreude.