Nobelist Paul Krugman Explains the Financial Crisis

Before he became known for his controversial new york times columns trashing the Bush administration, newly anointed Nobel laureate in economics Paul Krugman changed the way we think about trade, overturning 100 years of conventional wisdom that assumed rich and poor countries would trade equally with each other (in fact, a handful of richer countries end up dominating the system). He sat down with NEWSWEEK's Rana Foroohar to discuss the new economic era, politics and the prize. Excerpts:

FOROOHAR: So, of course we need to know: what was your reaction when you heard about the prize?
KRUGMAN: I was in a hotel room in D.C., stepping into the shower. My initial reaction was, "That's an obviously fake Swedish accent; this must be a practical joke." Then there were more Swedish accents, and I figured it must be real.

Most of your work was around trade: are you concerned about a push-back against free trade?
I'm pretty mild about it. World trade is already so free, we're really talking about stuff at the margins. I don't think protectionism is going to turn out to be a big deal. Whatever politicians say on the campaign trail, when you get to the White House, who wants to open up what would happen if the U.S. seriously went back on its trade commitments?

How did we get into the financial crisis?
Regulation didn't keep up with the system. As the shadow banking system evolved, more and more of the world's transactions were conducted by institutions that were not subject to traditional banking regulation. And because of the ideological environment of the times, there was no attempt to expand regulation. I think now it will be expanded, and securitization will be reduced, and mortgages in South Florida won't be held in Norway. I think it will be interesting to see just how much of the financial innovation we've seen turns out to be regulatory arbitrage. Someone once said that buying these derivatives [which brought down the banks] was like buying insurance for the Titanic from someone on the Titanic.

What will the fallout be in the real economy?
You'll see tighter lending, obviously. We'll also see compression of income at the top, which was dominated by people in the financial industry, so society may become a little less unequal. It will be pretty bad for New York as a whole.

Is it true that you believe the perfect socioeconomic model is Sweden in 1980?
In the summer of 1980, actually; winter there is terrible. But yes, it was very egalitarian, and democratic, with a high standard of living for all.

I ' m assuming you aren ' t advocating a 60 percent Swedish tax rate. How would you change the tax system?
We need more revenue, but I don't think that further soaking of rich people is necessarily the way to get it. Many countries with strong social safety nets rely largely on VAT tax, which is more broadly based.

What ' s your view of the bailout?
It makes more sense than it did before, but implementation is problematic. The recapitalization doesn't come with enough conditions for banks. There's too much ambiguity. Markets don't yet believe that Fannie and Freddie debt is government debt. Paulson is still a disappointment, but a bit less so than three weeks ago.

Where does U.S. capitalism go from here? Do we become more like Europe?
Or Canada. Basically, we're going to become less exceptional and more like a normal Western country. We're going to converge, but hopefully not in every way—we don't want to screw up our retirement system the way the French have.

What advice would you offer to a new U.S. administration?
On the economic front: we need a big fiscal stimulus plan, and fast. Also, pass legislation to increase health care. Don't let the crisis put that on the back burner. Politically, they should open up the records and see what actually went on over the last eight years. One of Clinton's biggest mistakes was not airing what really happened in Iran-contra. And then, the Iran-contra guys come back to do it all over again. Let's stop that this time round.