Paul Krugman presents a frightening figure. 

The figure [below] shows the real interest rates on corporate bonds, with
the expected rate of inflation from the spread between 20-year TIPS and
20-year Treasury rates. All data monthly, from St. Louis Fed.

I’ve been saying for some time that one of the signs of a credit crunch has got to be rapidly rising real rates – in very recent weeks, that appears to be happening.  The timing suggests to me that this is more of a deflation problem than a banking-credit problem per se but at this point who cares – we can probably all agree it’s more bad news.

Addendum: Greg Mankiw is also troubled by what this figure means.

Frankly, I am tired of this topic but every time I try to check the data – as best as I can – it doesn’t seem to support the rhetoric we are hearing from people at the top [despite real problems blah, blah, blah].  Here’s Paulson today:

At least some of the remainder [of the bailout money], Paulson said, should be used to
reinvigorate the market for credit cards, student and auto loans —
which combined account for some 40 percent of consumer credit.

"This market, which is vital for lending and growth, has for all practical purposes ground to a halt," Paulson said. (emphasis added)

I’ll focus on credit cards.  It is true that credit card offers, i.e. junk mail, is down:

…one billion fewer offers mailed during the course of the year.
Households with incomes under $50,000 will receive about 700,000 fewer
offers in 2008 compared to 2007. These households account for the
majority of the cutback and clearly indicate a major change in strategy
by card issuers.

"The souring economy and industry consolidation have driven volumes
down to levels not seen since 2003 [Crisis! AT]" said Andrew Davidson, Vice
President of Competitive Tracking Services for Synovate’s Financial
Services Group. "Card issuers are taking a more cautious approach, with
lower income and high risk households receiving fewer offers or no
offers at all."

But even so:

Despite the decline in offers for new cards, US consumers still
have access to an increasing amount of credit. Household credit lines
across all cards edged up to an average of $27,626 per household (YTD
3Q 2008) from $26,902 in 2007 despite evidence that issuers are cutting
credit lines on certain customers.

…"Much has been reported about issuers reducing credit lines for
certain customers but this is not the case for the majority of people.
Across the industry as a whole, we continue to see credit access and
usage at record high levels" said Davidson.

By the way, after listening to Tyler and me debate this topic Bob Murphy and Megan McArdle decided to run some tests.  So if you prefer your data by anecdote you can read Bob’s results here and Megan’s here.  I am partial to Megan’s hypothesis #5.

My little spat with with Rauchway regarding unemployment during the Great Depression draws in Paul Krugman.  Krugman doesn’t respond to any of my arguments but he does give us the old line that fiscal policy didn’t fail during the Great Depression it wasn’t tried.

Now, you might say that the incomplete recovery shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump. Here’s the Cary Brown estimates, from Brad DeLong…Net stimulus of around 3 percent of GDP – not much, when you’ve got a 42 percent output gap.

Now there is actually a lot of truth to this but the way in which Krugman, Rauchway, DeLong and others present this point is esoteric and likely to mislead even many economists.  What Krugman seems to be saying is that the government didn’t spend enough during the thirties (Rauchway, who also cites Cary Brown, says directly "there was never enough spending to achieve the desired effect.")  Yet federal spending during this time increased tremendously.  So what is really going on?  The answer is actually quite simple.

During the Great Depression federal expenditures increased tremendously but so did taxes.  Thus, the reason spending was not stimulative was not that spending wasn’t tried it’s that taxes were also raised to prohibitive levels.  But don’t take my word for it.  Read Cary Brown (JSTOR) whom Krugman, Rauchway, DeLong all cite but none of whom quote at length.  Here is Brown:   

The primary failure of fiscal policy to be expansive in this period is attributable to the sharp increases in tax structures enacted at all levels of government.  Total government purchases of goods and services expanded virtually every year, with federal expansion especially marked in 1933 and 1934.  [But] the federal Revenue Act of 1932 virtually doubled full employment tax yields…

…the highly deflationary impact of this tax law has not been fully appreciated…The Revenue Act of 1932 pushed up rates virtually across the board, but notably on the lower and middle income groups….Personal income tax exemptions were slashed, the normal-tax as well as surtax rates were sharply raised, and the earned-income credit equal to 25 percent of taxes on low income was repealed.  Less drastic changes were made in the corporate income tax, but its rate was raised slightly and a $3000 exemption eliminated.  Estates tax rates were pushed up, exemptions sharply reduced, and a gift tax was provided.  Congress toyed with a manufacturers’ sales tax, but finally rejected it in favor of a broad new list of excise taxes and substantially higher rates for old ones….

The Revenue Act of 1932 was followed by many further tax increases (e.g. Brown notes "…social security taxes began in 1937 to exert a pronounced effect…") many of them, under pressure from the Huey Long wing, designed to "Share our Wealth." Here is a graph of the highest marginal income tax rate which went from 25% to 79% between 1929 and 1940 and here is a graph of the lowest marginal income tax rate which (from a low base) increased by a factor of 10.  (Hat tip to Carpe Diem).

Thus, an accurate portrayal of fiscal policy during the Great Depression – entirely consistent with Krugman – is that we had much greater spending, much greater taxes and not much economic stimulus.  And if supporters of the New Deal argue that fiscal policy was only "modestly expansionary" then it’s quite reasonable to think that once we take into account the supply side effect of taxes and the increase in regime uncertainty then the net effect might even have been contractionary. 

It’s surprising how often I agree with Dean Baker.  In It’s the Housing Bubble, Not the ***** Credit Crunch he writes:

No one will lend me $1 billion, that’s how bad the credit crunch has gotten. There are probably reporters at major news outlets who would print that.

…they are still badly misinforming the public, first and foremost by attributing the economic downturn to a credit crunch.

This is truly incredible. Homeowners have lost more than $5 trillion in housing wealth. There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption. This implies that the loss of wealth to date would cause consumption to fall by $250 billion to $300 billion annually (1.7 percent to 2.0 percent of GDP). If you add in the loss of around $6 trillion in stock wealth, with an estimated wealth effect of 3-4 cents on the dollar, then you get an additional decline of $180 billion to $240 billion in annual consumption (1.2 percent to 1.6 percent of GDP).

These are huge falls in consumption that would lead to a very serious recession, like the one we are seeing. This would be predicted even if all our banks were fully solvent and in top flight financial shape. Even the soundest bank does not make loans to borrowers who it does not think can pay the loans back (except during times of irrational exuberance).

Greg Mankiw’s memo to the president-elect is excellent. 

China’s economic difficulties are very worrying because in China an economic slowdown is not just an economic problem but a political problem.  Will the Chinese leadership turn to nationalism to divert attention from problems at home?  Interesting times. and this time that is a curse.

China needs to encourage domestic consumption and with a trillion dollars in reserves they have the funds.  Spending the rainy day fund would benefit the U.S. as well, stimulating our exports.  It may already be too late, however, to shift smoothly from export to domestic consumption which means that mass capital depreciation will occur as capital investments in export industries turn out to be worth less than first appeared.