I did actually address the issue you are raising above. I did so in the paragraph “The diligent pseudo economist,” and the 3 following ones.

The government can’t fix the crisis by printing money and buying up factors of production for some purpose. The reason being that the fix in itself is the fact that prices for those assets are falling back to normal levels that reflect the consumers’ value preferences. And the reason they are falling is excessive government intervention beforehand. Interfering with this process fixes nothing. It only aggravates the crisis.

The main objective has to be to employ productive factors where they are useful again, as far as consumer judgment is concerned.

Put yourself in the shoes of a benevolent government bureaucrat. Say you print up $1,000,000 and are charged with the task of properly allocating factors of production that are available on the market at some price. The fact that they have a price tells you that they are already tagged by other investors who would also be interested in purchasing them. The tag says “This is my factor of production, unless you are willing to pay more.”

Now the first question will be: What will you produce? Are you going to drill for oil? Or rather build windmills? Or set up another Starbucks? How do you know what people need most right now? But for the sake of the argument let’s assume you do know for some magical reason.

Now you need to obtain the productive factors needed to turn out the products needed. How do you know which ones to obtain? Do you use wood or concrete or steel for your windmill? What kind of people do you hire? How do you know they are not of more use elsewhere?

But again, let’s say for the sake of the argument, you are omniscient and know. You obtain the factors of production and produce the products you think are needed. Now how do you know the consumers like those products? How do you know whether or not changes to them are needed? From a bureaucratic perspective, you have done your job. But you have not done anything for the improvement of the common welfare.

You don’t have the indicators that an entrepreneur has to help you determine whether or not the goods are actually needed more urgently than those that alternative uses for the factors of production would have turned out.

All this has been fully explained by the theory of bureaucracy (http://www.economicsjunkie.com/the-trouble-with-bureaucracy/).

I actually was in Germany and just got back. Too bad we didn’t get to hang out. When are you coming over here? :)

nice post, enjoyed reading it. Now I am anything but a macroeconomist, but I had to take an introductory class on keynsian economics during my first year at uni.

So the following comment will be based on that level of knowledge ;).

I think Krugman is making here a number of standard keynsian assumptions, but does not do so explicitly. That seems to be the reason why you find it so difficult to follow him.

For example, he obviosuly assumes that governments use debt instead of taxes to finance their spending (”deficit spending”).

Now, while government borrowing indeed crowds out private investments in normal times, it does not do so when the economy is in an “investment trap”.

In a nutshell: If the economy is in this sort of trap, private agents do not invest even when the interest arte falls to zero because they have extremely low expectations for the future.

In this situation, when actual employment falls below the production possibility frontier of the economy due to some sort of crisis of confidence, government spending can indeed stabilize the economy (increase output) in the short run by bringing it back to the production possibility frontier WITHOUT crowding out private investments.

Of course, confidence will eventually return and the economy will reach, in the long run, the production frontier even without any government intervention. But then again, you might need to wait a really long time and to incur massive political costs in the meantime…

So the point about deficit finance is that it is a short-term policy. According to keynsian theory, you can increase GDP in times of economic crisis — when output is lower than it could be, but you cannot increase it in the long run, where the level of output is only determined, as in the neoclassical school, by capital stock, technology and the like.

Krugman is thus not advocating Krugmanland, but only standard keynsian recipes :)

Now people have obviously criticized the concept of the investment trap, and i am not sure whether it actually can exist, and even less whether we are right now in such a trap. But I do think that it is a reasonable concept about which you can, at least, talk…

When will you be back in Germany? See you soon…