TERRY GROSS, host:

This is Fresh Air. I'm Terry Gross. My guest, Paul Krugman, won the Nobel Prize for economics last week. Krugman is a columnist for the New York Times and a professor of economics and international affairs at Princeton University. The Nobel was specifically for his academic work analyzing trade patterns.

His book "The Return of Depression Economics and the Crisis of 2008" will be published in December. It's an expanded and updated edition of the book he published in 1999. His book, "The Conscience of a Liberal," which is also the title of his blog, will be published in paperback early next year. We invited Paul Krugman to talk about the financial crisis.

Paul Krugman, welcome back to Fresh Air and congratulations on the Nobel. It's so terrific. How were you notified?

Dr. PAUL KRUGMAN (Professor of Economics and International Affairs, Princeton University; Recipient of 2008 Nobel Prize in Economics): My cell phone rang. I was actually in Washington for a meeting. And my cell phone rang as I was about to step into the shower, and some guy with an obviously fake Swedish accent (unintelligible). It was completely - just like that. Just out of the blue.

GROSS: Did you feel confident it was the real thing and not like a prank phone call?

Dr. KRUGMAN: No. Actually, I wasn't entirely convinced until it actually popped up on the Nobel website. So it's just one of those things. It's a little hard to take on board.

GROSS: You know, it's hard to see how we're ever going to pay down the debt from the war and the bailout. But in a recent column, you said increasing government spending is just what the doctor ordered, and concern about the budget deficit should be put on hold. And along those same lines, the president of the bipartisan Committee for a Responsible Federal Budget said right now would not be the time to balance the budget. So why do you think now is the time to spend as opposed to worrying about the deficit when the deficit is so big?

Dr. KRUGMAN: Well, the deficit is big, but it's not enormous as a share of GDP. It's big. It's certainly something that if it was built in, if it was structural, to use the jargon, we'd worry about it a lot. But a lot of what we're talking about right now is temporary measures, and, you know, it's an emergency. You're expected to run deficits when you have an acute emergency, whether it's a war or an economy that's sliding into what could be a very, very serious recession.

So now, this is the time when the economy needs support. After things have come back, after business investment is strong, and the economy really doesn't need this kind of support, that's when you say, OK, let's look at some belt tightening, but not now.

GROSS: So what kind of extra spending do you think we should be doing to help the economy get back on its feet?

Dr. KRUGMAN: The most effective thing you can do is to actually go and spend the money right. The tax cuts, which are often the proposal, there's this problem, which is people may just sit on them. So if the government actually goes out and spends money and better still, if it spends money on things that are good to have anyway, like repairing infrastructure, that's good.

First line of things to do, I think, is aid to state and local governments because they are actually slashing spending on bridge repair and roads and so on because of their fiscal problem. If you can give them money, that has an immediate positive impact because it leads to avoiding some of these cuts. And then we can go down the list, but we have a fraying infrastructure in this country, lots of work to be done, a lot of things that can be done pretty quickly as my understanding.

So a few other things, we can provide increased aid to be people with extended spells of unemployment because there's going to be more of them. They're going to need it, and they're also likely to spend the money, again, because they need the money. So, there's a list of things. But, you know, a little bit think of '30s, think of the Work Progress administration. We are in, at least potentially, a situation that bears more resemblance to that than we'd like to think of, and do the same kinds of things all over again.

GROSS: Here's one of the very many things I don't understand about what's going on now with the economy. We are in such debt, and yet at the same time, we're bailing out the banks and raising FDIC insurance. So since we don't have any money right now, as the federal government basically has no money, it's in debt, so where is this money coming from that we're using to infuse the banks with money and prop up the FDIC?

Mr. KRUGMAN: Well look, the federal government has got very good credit, despite all - because ultimately, the federal government has the U.S. economy as its tax base, and, you know, the United States is not a heavily taxed country by international standards. It may feel like we are when you have to fill out your 1040, but the fact of the matter is, there's lots of potential revenue there. It's a big economy. It's not going away. So the federal government has the ability to borrow.

It is, in some ways, the world's ultimate safe haven for money. So at a point when you got this credit crunch, when lots of people who really should be able to borrow aren't able to, the one institution out there that really can borrow and therefore can supply the credit the economy needs is Uncle Sam.

GROSS: I guess I'm confused about why countries like China would think that our treasury bonds are still so safe when our economy is in such jeopardy?

Dr. KRUGMAN: It's a long way from the kinds of debt we have to the kinds of debt that can make a country really end up defaulting. You know, we are not Argentina. We are working on it a little bit, but we are not Argentina. And I like to talk - being kind of an international economics guy, I like to talk about other advanced wealthy countries and their ability to continue paying their debts.

So you look at countries like Belgium. Belgium has had debts which are more than twice as large relative to the economy as ours. They have a weak political system because they're torn between different linguistic groups, and yet, they do pay their debt. They do manage.

Advanced wealthy countries have an enormous ability to pull up their socks, you might say, in the long run. Give us a chance, and we can do it. We came out of World War Two with enormous debt. We paid it off in full. So it's very difficult to come up with a story in which the United States government is a bad debtor. You can do it. It can happen. But we're nowhere close to the point where the numbers suggest that you ought to be worried.

GROSS: Is the Federal Reserve printing more money in order to do this infusion of money into the banks and bailout the FDIC and Fannie and Freddie, etcetera, etcetera?

Dr. KRUGMAN: No. I mean, it turns out that no, we're not at that stage. I don't think we ever will be. With the amount of money that's actually printed, it's pretty much determined by the demands of the economy, not by the demands of the federal government. All of this stuff is being paid for by issuing debt. I mean, the stuff that Ben Bernanke, my former department chairman at Princeton, is doing is mostly being done by...

GROSS: I never thought of it that way.

Dr. KRUGMAN: Yeah, it's a - there's a big conspiracy there. The big - everybody running things seems to be from Goldman Sachs, but in the secondary positions, it's all people from Princeton.

Anyway, but Ben is - you know, he's doing most of these new things that the Fed has done by selling off some of the Fed's portfolio of treasury bills, which is U.S. government debt, and buying other stuff instead. And what that amounts to, if you think about the system as a whole, is, in effect, the public is buying up more federal debt, and that's providing the funds. So no, this is all ultimately being backed by faith that the markets and the tax collecting ability of the U.S. government.

GROSS: So you're saying taxes are going to go up. Yeah, is that what you're saying?

Dr. KRUGMAN: Well, a little. But, you know, if you actually try and do this, even - you know, we're a $15 trillion economy - $15 trillion a year. All of the bailout stuff that we've been talking about is an initial outlay, which is probably going to go above a trillion dollars, but some of that is going to come back because it's going to - much of it is going to come back because it is actually buying assets. And when you try to take several hundred billion dollars, which sounds like it is an enormous amount of money, but you put it against an economy that generates $15 trillion worth of stuff every year, year after year, it's not a big tax increase that's required. It's something that in some ways will, if all goes well, we will barely notice.

GROSS: Let's talk about the bailout plan. You didn't like the initial idea of buying the toxic assets. You prefer the new plan of giving infusions of cash to the banks by buying preferred stock. What didn't you like about the initial plan of buying the toxic assets?

Dr. KRUGMAN: It wasn't clear how it was supposed to help the situation. The basic story of how does this housing bust translate into an overall credit crunch? Why are people who are not trying to borrow to buy houses still finding it hard to get credit? Why are we seeing so many markets kind of shrinking on themselves? And the reason is that banks and bank-like institutions were owning a lot of mortgage-backed securities or owning, you know, what everybody right now calls toxic waste, were owning this stuff that was backed by mortgages, especially subprime mortgages, and that stuff suddenly lost a lot of its value, which in term meant that the banks didn't have the capital they needed to do their business.

Banks have to have a certain amount of money, that their assets have to be worth more than their liabilities, or nobody's going to deal with them. And that margin, that capital was severely damaged by the whole crisis. So the reason that the housing bust, you know, propagates and becomes - the domino effect comes through lack of financial institution capital. So along comes Henry Paulson, U.S. Treasury, and says, what we're going to do is, we're going to buy up some of the toxic waste and take it off your balance sheets, take it off your hands.

And the question is, how does that help the capital, which is the core of the problem? If Paulson pays market value for the stuff, then the capital position is as bad as it was before because the stuff was deeply devalued, and all you're doing is sort of recognizing the losses. If he pays above market prices, then it's a sheer give away to these financial institutions. And how do you justify that? So, there was never any explanation of how this thing was supposed to work.

The right thing to do is to say, OK, we're going to give these institutions more capital, and we're going to do it in the same way that a private investor giving an institution more capital will be, which is, we'll take an ownership share. We'll give you the extra 10 billion or 20 billion or ultimately probably about 500 billion that you need to operate and do your job. And in return, we're going to take $500 billion worth of the ownership, so that if and when things get better, the taxpayers share in the upside.

GROSS: So we're basically buying preferred stocks in these banks?

Dr. KRUGMAN: That's right, and there is a question about exactly - we can try to parse the details. I think it could have been done better, but this is the time honored recipe. This is what, in the end, the Japanese did to resolve their crisis. It is, in fact, what FDR did in the '30s to help resolve the banking crisis. It's partial, you know, partial nationalization, in effect, which is something that is, in fact, the normal, the sensible approach to these crises.

GROSS: I think one of the goals here of buying these - the preferred stock in the banks that need help is that the banks will now have money to make loans again and thus unfreeze the credit markets. But from what I've been reading, some of the banks are just basically hoarding the money, and they'll be using it to pay back creditors maybe, but not necessarily to make the loans that need to be made to unfreeze the credit markets. So, what can you tell us about that?

Dr. KRUGMAN: Yeah. There is a question. I am a fan of the British approach, which has been much more aggressive and hands on than the U.S. approach. They have actually taken voting rights in the institutions they've been bailing out, the British government has, and they've been sort of making additional lending condition of the money. And the United States still - I mean, we sort of had to drag Paulson and the Treasury Department kicking and screaming into doing anything like the right thing. And they're still trying to sort of make it as immaculate, as hands off as they can, and that is a problem. But even so, the prospect of increased capital, the prospect that the banks will be more able to lend helps.

And, in fact, as of Monday, there are visible signs of a thaw in the markets. The change in direction that took place last week really is getting us somewhere. The financial crisis, it's still terrible, a stress measure, you know, various things you look at to say how are the markets by historical, by normal standards, it's still awful out there. But it's visibly less awful than it was just a few days ago. So I think, actually, this thing is working.

GROSS: What do you think the chances are that taxpayers will make a profit from the preferred stocks that we bought in the banks?

Dr. KRUGMAN: Well, a little bit less than even. There's an honest dispute about whether these things have been really undervalued or not. My guess is, we'll probably make a loss, but it won't be huge. You want to think about, you know, even the savings and loans, which is our precedent, where we effectively - we nationalized quite a few of the S&Ls back in the late '80s or early '90s, and there, they were clearly bust. There was no prospect that the taxpayers would get all of their money back. But we got a fair bit of the money back. So, you know, when you look at these headline numbers, when you look at $700 billion, that's - the ultimate cost is going to be a lot less than that.

GROSS: Have we entered some form of quasi-socialism by becoming part owners of the banks?

Dr. KRUGMAN: Yeah. It is part nationalization. They sometimes go around saying, Commissar Paulson has seized the commanding heights of the economy.

(Soundbite of laughter)

Dr. KRUGMAN: You know, there is that aspect to it. It is, you know, lots people are getting whiplash over this. But look, I don't think anyone expects that this would be a sustained thing. It's going to be like Sweden in the early '90s. They really just did nationalize several of their major banks, but they did eventually re-privatize them again. But sure, it did - the government has turned out to be the owner of last resort in these kinds of problems.

GROSS: So let me get back to our friends, the toxic assets. Does the Paulson plan definitely no longer include buying them, or is it still possible that buying some of them will be part of the plan?

Dr. KRUGMAN: I hope that it's not part of the plan, but it's still, you know, the bill that Congress passed does certainly allow Paulson to do that. And there is this feeling that I think a lot of us who've been weighing in on the crisis have that we're trying to shepherd Paulson into doing the right thing, and he's always kind of trying to wander off to the sides. So maybe the Treasury will, in fact, go back to trying to say, well, what we want to do is buy up the mortgage-backed securities, not put capital into the banks. But, at least for now, it looks like they're - the focus is on preferred shares and capital injections, to use the jargon, which is better.

GROSS: My guest is Paul Krugman. He won the Nobel Prize in Economics last week. He's a columnist for the New York Times and a professor of economics and international affairs at Princeton. We'll talk more about the financial crisis after a break. This is Fresh Air.

If you're just joining us, my guest is Paul Krugman. He is a columnist for the New York Times, and he just won the Nobel for Economics, to which I say congratulations, again. And he also has a book that's coming out in December, and it's a new edition of a book that was initially published in 1999. The new edition will be called "The Return of Depression Economics and the Crisis of 2008."

Let me get to yet another thing that I'm finding awfully confusing, and that is - you know, there's this expression, too big to fail, that certain banks are too big to fail. You have to prop them up or else the repercussions would be just unthinkably severe. So in this era where things have become too big to fail, some things have become even bigger, like Bank of America now owns Merrill Lynch. So, how big is that? I mean, now that we know that some things are too big to fail and fail anyways, some of those entities have become even larger.

Dr. KRUGMAN: Well, sure. It's - you know, though, it turns out that it wasn't so much the bigness as the - sometimes people now use the expression too connected to fail. You know, we had a test of it with Lehman Brothers. The Treasury decided, well, OK, they are not so big, and we can let them fail, and nothing terrible will happen. And so, they let Lehman fail, and something terrible did happen. Basically, world markets fell apart. This acute phase of the crisis began with that decision. So, too connected to fail is not a theory. We've seen that demonstrated with great pain just recently. And yeah, institutions get bigger.

But, you know, this is the point, actually. Those of us who say we need a lot more regulation, if there is an institution that has to be rescued in a crisis, then they have to be regulated so they don't abuse the safety line. You know, we've always known that banks with insured deposits need to be regulated. You are giving them a privilege, insured deposits, in return for some oversight that they weren't allowed to play games with that federally-guaranteed money.

Now, we've discovered that there are institutions that don't take deposits that turn out to be just as critical. That there isn't officially insurance, but sure enough, when the crisis comes, you have to have the federal government backing them. And anything that needs to be rescued like a bank now needs to be regulated like a bank. So the answer is not, well, you know, this thing is getting too big. What happened to competition? The answer is, OK, the system turns out to need a lot more regulation management oversight than we thought it did.

GROSS: What moves have we made in that direction? What moves do you think we should make in that direction?

Dr. KRUGMAN: So far, we've done almost nothing on the regulatory side. So far, it's all been firefighting. And, you know, to some extent, that's right. You know, if you're - if the building's blazing, you put out the fire, and you worry about putting in a sprinkler system later. But do we need those. We need - we actually have a pretty good idea of what's needed because what we really need to do is, we need to take all of these non-depository institutions, the Lehman's, the loan originators, all of the institutions that have been the heart of this crisis that were not typical banks.

I mean, the way I like to think of it is, once upon a time, they were banks. They lived in big marble buildings. They took deposits. Those institutions were at the heart of the crisis of the 1930s, so we regulated them. We gave them deposit insurance. We regulated the amount of capital they had to have. We told them they had to hold certain reserves, and we sort of made that system safer.

Now, it turns out, there are all these institutions that aren't called banks, and they don't live in big marble buildings, but they play the same role in the 21st century financial system that those big marble buildings did in the 1930's financial system, and they need to be regulated pretty much the same way that the old-fashioned banks of marble needed to be regulated.

GROSS: And you're talking about the investment banks here.

Dr. KRUGMAN: Investment banks, hedge funds, loan originators, the Countrywide - all of these, this whole thing, the shadow banking system, the parallel banking system, various names for it, all the things. Basically, anybody who borrows short and lends long is a bank, as far as the economic is concerned, and should be regulated like a bank.

GROSS: Paul Krugman will be back in the second half of the show. He won the Nobel Prize in economics last week. He's a professor of economics and international affairs at Princeton University and a columnist for the New York Times. I'm Terry Gross, and this is Fresh Air.

This is Fresh Air. I am Terry Gross. We're talking about the financial crisis with Paul Krugman. He won the Nobel Prize in economics last week for his work analyzing trade patterns. Krugman is a columnist for the New York Times and a professor of economics and international affairs at Princeton University. His book, "The Return of Depression Economics and the Crisis of 2008" will be published in December. It's an expanded and updated edition of the book he published in 1999.

Watching what's happening financially now is really a lesson in the global economy. I mean, Sovereign Bank in the United States was just bought by a Spanish bank, and we've been seeing this pattern happening of banks from one country being purchased by banks of another country. So, the interconnectedness of our economies is getting to be even greater than it was before the financial crisis. What does that mean?

Dr. KRUGMAN: Sometimes, I'm a little bit skeptical about the flat world and all that. But the financial linkages are now much tighter than they used to be. I actually put a little technical paper up on my blog, the "International Finance Multiplier," because it's about the ways in which we've gotten linked. And it's not just a question of that Spanish company owning my local bank or something like that. It's the - we have these financial players who are investing in many places and have financial positions that depend on events.

They unlocked the world, and they do create these incredible linkages that we - we used to talk about that in a case of third-world countries. We talk about how default by Russia would lead to hedge funds having to pull back everywhere. So, a default by Russia, it could lead to a financial crisis in Brazil. But that was only supposed to happen to, you know, small developing countries. Now, it happens to everyone. We have defaults on Florida condominiums end up producing havoc in Germany. And that's a more tightly linked world with hazards of a type that we didn't take seriously before.

GROSS: Henry Paulson, the secretary of the Treasury, is the former head of Goldman Sachs. He has been the major designer of the bailout plan. He is hiring the people to run the bailout plan. What do you think the pros and cons are of having someone from the banking industry overseeing the plan to bailout the banking industry?

Dr. KRUGMAN: It is a problem. It's not a problem I know how we can solve right immediately because of, basically, what we've done to our government. Now, I don't have any reason to think that Paulson is, you know, being venial, that he is actually, you know, deliberately setting out to enrich himself for his - or his friends.

But there is an issue. Some people have called it cognitive regulatory capture, that if everybody who is involved in this is an investment banker, then they tend to think of this from an investment banker's point of view and tend to think basically that what is good for Goldman Sachs is good for America. And that is a problem.

The problem, however, is more than just Paulson. The problem is that we don't have the kind of Treasury Department that has a deep bench of people with expertise who could deal with these issues. In some ways, this is what's happened under the Bush administration. All through the government, professionals, people who really know their stuff, civil servants who have been overseeing particular areas of concern for decades have left, and there's been a lot of politicization, a lot of replacement by people who don't know their stuff that well, which leaves them with no alternative.

There isn't, as far as I can make out, a team at Treasury who could do this bailout planning. They need the people from the investment banking sector. But that's because they don't have the civil servants they used to. If you want a comparison, Britain, you know, her Majesty's Treasury doesn't seem to be hiring lots of people from the city of London the way that the U.S. Treasury is hiring people from Wall Street, and that's because the British Treasury has not suffered the kind of erosion of professionalism than, unfortunately, the whole U.S. government has.

GROSS: You compared the Treasury Department to FEMA.

Dr. KRUGMAN: Yeah, the FEMAfication is my patented term here. And, you know, I don't think this is bad as FEMA. But everyone I talked to says that this is not the Treasury Department we had 10 years ago, certainly not the Treasury Department we had 30 years ago. We don't have the kind of deep understanding core of dedicated civil servants. You know, people think of government as necessarily consisting of useless bureaucrats, but actually, a good government has a lot of people who really know their stuff, and we're kind of short on those these days.

GROSS: Ben Bernanke, the head of the Federal Reserve Bank, is your former department head at Princeton. He studied the Depression. What do you think he learned from it judging from what he's been doing?

Dr. KRUGMAN: He studied the Depression, and he also studied Japan's decade-long slump - so, which is, you know, both of those. He's a scholar of economic troubles. And what he learned from it is that you don't pull your punches. If you see something that looks anything like the beginnings of the Great Depression, you hit it hard, very aggressively. You do sharp interest rate cuts. You provide lines for credit. You do all kinds of things to make sure that you're really getting, you know, jumpstarting the whole system. Don't let it slide into a stall.

The tragedy - I think this is something that gives all of us pause - is that he's done all of those things. And it still hasn't worked. So, I can't think of anybody who is better suited to cope with the current crisis than Ben Bernanke, but, in fact, at least so far, all of the things that he learned from previous crises applied to the current one has still proved inadequate.

GROSS: What do you think it has proved inadequate?

Dr. KRUGMAN: I think the problems are bigger than we had grasped. I think what happened was that nobody understood or at least very few people understood the extent to which this 21st century financial structure was vulnerable. Nobody understood the extent to which we were really capable of having falling financial dominoes. And the result of that has been that what looked historically like extremely big measures are actually still way short of coming to grips with the scale of the problem.

GROSS: Christopher Cox is the head of the Securities and Exchange Commission, and he is now calling for the regulation of credit default swaps, which are those derivatives with a lot of mortgages. It's kind of like insurance by another name for the mortgage security. So, he's calling for their regulation. Do you think he should have been calling for that a lot sooner?

Dr. KRUGMAN: Oh yeah, I mean, there were people warning about those long before this crisis hit. And he certainly should have. I mean, now, I'm not sure if this is fair to him or not, but to put it in context, there were very influential people who are adamantly opposed to any kind of regulation, among them Alan Greenspan. So, Cox would really have to have been sticking his neck out to say, well, I think we ought to be doing this, and I'm right, and the great Alan Greenspan is wrong. But sure, it's clear that they created a dangerous illusion of security in the system, and now, they look like one of the causes of the crisis.

GROSS: When you look over the past few years, who do you think is most responsible, if this is a fair question, for the meltdown?

Dr. KRUGMAN: OK. So, you know, there's no villain who caused the meltdown. The meltdown was caused by greed followed by fear. It's caused by a housing bubble and the greed of people who rushed in to make money off it and then their discovery that they'd actually done a bad thing that turned into this panic in the markets. So, the villains that we really look for are those who stood in the way of any protective measures, people who were warned that there were risks out there but failed to act on those warnings and, in fact, actively prevented any action. The top of my list is Alan Greenspan.

GROSS: Why?

Dr. KRUGMAN: He was warned there was a housing bubble and dismissed it. He was warned that these derivatives, including credit default swaps, were a potential big problem, and he actually actively insisted that they were great things. They were actually eliminating much of the risk in the system. He was warned about subprime lending and refused to take action. So, Greenspan's faith that the market is always right did a lot to create the preconditions for this crisis.

GROSS: Let me ask you, we've been talking about, like, the macro picture in the global economy. Talk about us for a second. Like, we Americans, who have no idea what to expect now, people are worried about paying their mortgages, about keeping their jobs, about having enough money to send their kids to college, and paying their bills and all of that. What sign should we be looking for that things aren't going to keep getting worse? At what point can we have some kind of confidence that at least it's stabilized?

Dr. KRUGMAN: Wow! You know, I look a lot at these financial stress indicators, and I'm looking for signs that those are getting a little better. But those are just talking about the acute phase. We're really just talking about whether, you know, whether the economy is going to bleed to death in our arms here.

For most people, what matters more is, what about the real economy? What about jobs? What about wages? And there you are, you know, you want to look at the sort of conventional headline numbers. What's happening to the unemployment rate? What's happening to job creation? What's happening to industrial production? And I have to say that all of those things are pointing steeply downhill now. You know, even if we get some of this sort of panic in the markets under control, there's a lot of downward momentum in the job market, in the real economy. People should be watching for a turnaround there. But I would be very surprised if things don't get substantially worse before they get better.

GROSS: And define substantially worse.

Dr. KRUGMAN: Unemployment rate, seven and a half, possibly eight percent, quite probably, I would, say the worst recession since 1982. Jobs much harder to find, lots of wage cuts as companies are in trouble, a lot of hardship out there. We haven't had a really nasty slowdown in the economy. We've had some troubled times. But we haven't seen real severe ones since - in 25 years, and this looks like it has all the makings of it. So, this is a situation where a lot of middle-class Americans are going to find that their middle-classness has suddenly been taken away from them.

GROSS: My guest is Paul Krugman. He won the Nobel Prize in economics last week. He's a columnist for the New York Times and a professor of economics and international affairs at Princeton. We'll talk more about the financial crisis after a break. This is Fresh Air.

If you're just joining us, my guest is Paul Krugman. And he just won the Nobel Prize for economics. He's a columnist for the New York Times, and a book that he wrote in 1999 is going to be published in a new edition in December, and that would be called, "The Return of Depression Economics and the Crisis of 2008."

Looking at the European approach to the financial bailout and the American approach, what conclusions does that lead you to about the differences between European capitalism and American capitalism?

Dr. KRUGMAN: Well, you know, Europeans got caught up in the mania just like we did. Even if they have much more elaborate social safety nets, and in many ways they, you know, they're farther to the left than the United States is ever likely get, nonetheless, there are plenty of European banks that went wild in their lending and took up big risks and in some ways maybe even more so than our own, and at least in some countries. So the European response has been not that different from the U.S. response.

But they have gotten a little bit ahead of us in the last few weeks. So, they have proved more willing to face up to what has to be done. And there, I think, there is some difference. You can just see that we still have these hang ups about - we can't have the government taking an active role in dictating what banks ought to do. The Europeans don't have that problem, which I think has helped them a little bit.

GROSS: Iceland's banking system collapsed, and because they were offering such high interest rates for a while, investors from a lot of countries had their money in Iceland. And so what is the lesson from what happened in Iceland?

Dr. KRUGMAN: Well, you really shouldn't be a financial center. You shouldn't be playing the role of a hedge fund country if you don't have the resources to bail out the system if it all goes wrong. I mean, in some ways, Iceland was playing the role that Wall Street is playing or the city of London is playing. But Wall Street is embedded in a very large country, the United States, and we can come to its rescue. The city of London, not quite so much, but still, you have a country of 60 million people that's backing it up.

Iceland's banks were playing a big game, and they did not have a backstop. This was scary. This was a case of, you know, a country that's got roughly the population of, I don't know, Sommerville, Massachusetts that was playing in the big leagues financially. And it should not have been.

GROSS: Can I ask for your kind of quick impressions of how Obama and McCain are talking about dealing with the economic crisis?

Dr. KRUGMAN: What strikes me about McCain, first, is that he's still trying to shoehorn this thing into a framework that he has believed in for all these years. He wants to believe that it's excessive government, that is the problem always. He really is a deregulator, and so he puts Fannie and Freddie, the government-sponsored lenders, at the core of the crisis, when even five minutes with the numbers tells you, actually, that they were not major players in the huge wave of bad lending that created this.

But McCain always goes first to the government's side. Ask him what you're going to do about the crisis, he starts talking about eliminating earmarks, which has nothing to do with it. So he really is at sea. This is not part of his mental universe. Things like this are not supposed to happen. The need for government regulation, you know, he said - now, he says he's in favor of it, but this was never a part of his world view.

Obama is clearly much more comfortable with this. He's been a pro-regulation guy. He's been a moderate government interventionist all along. He has not taken a leadership role in responding. I think I would say that actually, among Democrats, Obama's inner circle of advisers were relatively free market, relatively unprepared for this. But they're smart, and they're intellectually flexible, so he's been able to respond quickly to what's going on.

So, fundamentally - I mean, basically, McCain is a modern Republican, and Obama is a modern Democrat. And modern Republicans are unprepared for a 21st century that somehow looks an awful lot like the 1930s. And modern Democrats are - fall pretty easily into the role of saying, OK, it's FDR time again.

GROSS: Well, just one more question. Is there something just kind of fascinating for you, as an economist, to be living through and writing about this really difficult time? As difficult as it is, is there a part of you that's standing back and watching it with great intellectual fascination?

Dr. KRUGMAN: Oh yes, I mean, I do feel guilty about it all the time. But professionally, I'm, you know, in hog heaven. It's a little bit like I imagine like a hurricane expert watching an extraordinary hurricane. Even though it's going to wreak devastation, you're also fascinated. And particularly, you know, before I went to work for the Times, I was a little bit of an economics ambulance chaser. I did do a lot of work on crises and going to the place where crises were in progress, which meant flying off to Jakarta or to Buenos Aires. Now, I can take New Jersey Transit to the center of the crisis.

(Soundbite of laughter)

Dr. KRUGMAN: And so here is it, the most awesome crisis of my lifetime, and it's taking place right on my doorstep. And it is intellectually very interesting. As a citizen, I'm terrified. But as an economist, I'm really having a very interesting time.

GROSS: Are you terrified or merely worried?

Dr. KRUGMAN: I'm fairly terrified. I mean, I'm looking at this and saying, you know, I don't think the worst is going to happen. But I'm looking at - I'm thinking about the fact that Ben Bernanke, somebody I know, someone who is intellectually as prepared as anybody can be for what's happening now, and he's still having a very hard time getting a grip on it. And that's pretty disturbing. It makes me wonder, you know, how sure are we that we know how to prevent the worst from happening. I still think we do. But six months ago, I would have assured you that Ben knew what to do because he was doing what I would have done. And I thought we knew what to do. And now, I'm not so sure.

GROSS: Paul Krugman, thank you so much for talking with us. And congratulations on the Nobel.

Dr. KRUGMAN: Thanks so much.

GROSS: Paul Krugman won the Nobel Prize in economics last week. He's a columnist for The New York Times and a professor of economics and international affairs at Princeton University. This is Fresh Air.

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