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If you haven't been following the debate going on worldwide whether governments should be increasing fiscal stimulus or cutting deficits, you might want to start paying attention. As Paul Krugman writes, we might very well be insuring a decade of misery with the choices being made right now:

Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as "depressions" at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of 1929-31.

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost -- to the world economy and, above all, to the millions of lives blighted by the absence of jobs -- will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world -- most recently at last weekend's deeply discouraging G-20 meeting -- governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

Inflation vs. deflation; belt-tightening vs. expansionary fiscal policy. These are the dilemmas we're facing, and it seems as if the policy makers around the world are choosing to cut spending in the face of clear evidence that it is precisely the wrong thing to do:

In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today's governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.

But future historians will tell us that this wasn't the end of the third depression, just as the business upturn that began in 1933 wasn't the end of the Great Depression. After all, unemployment -- especially long-term unemployment -- remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.

In the face of this grim picture, you might have expected policy makers to realize that they haven't yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.

Krugman continues:

Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it's true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners' medicine.

It's almost as if the financial markets understand what policy makers seemingly don't: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.

The fact of the matter is that interest rates, the "canary in the coal mine" of inflation (interest rates go up when economic activity - and hence inflation - go up) are at levels last seen in the midst of the credit crises of 2008!

Again, Krugman takes us down memory lane in this blog post:

First, there was a run-up in interest rates in the spring of 2009 -- mainly a reaction to receding fears of a second Great Depression, but widely interpreted as a sign of impending fiscal doom. Then rates went back down.

Second, there was a big scare in the fall of 2009, based on, well, nothing -- which is what led me to write my original post on invisible bond vigilantes. And fear of this phantom menace helped scare the Obama administration away from a second stimulus.

Finally, there was the bond scare of March, in which we were turning into Greece because of a blip in rates barely visible on the charts. Since then, rates have plunged.

So what's with this infatuation with our short-term budget deficits? Brad De Long thinks it's because most folks just haven't done the math:

Whether we spend an extra $100 billion more (or less) this year on anti-recession measures is unimportant--is less than rounding error--in the long-term budget context.

Let's do the math:

Spend $1 billion today. Use the Treasury to borrow the money for 10 years at 3.20%. Expected inflation at 2 1/2% means that the real interest charges on the borrowing are only $7 million a year. And in 25 years the real American economy will be twice it's current size, and so the burden of raising taxes to actually pay off the debt will be half as big as it is today.

So, the interest on $100 billion is $70 million/year or $1.5 billion over 25 years, but the economy will be twice as large then, so you can cut that $1.5 billion in half = $750 million over 25 years. Let's make the stimulus $1 trillion and you get $7.5 billion over 25 years. A mere rounding error in a $20 trillion economy.

And Kevin Drum goes even further:

What's the downside of more stimulus vs. less stimulus? The downside of less stimulus, I think, is obvious: if the Krugmanites are right, it will mean years and years of grinding unemployment and slow growth. It means pain and destitution for millions.

But what's the downside of more stimulus? No one can say, really. The best answer is that it might lead to future interest rate hikes or future inflation or future tax increases. But there's very little evidence to support this, and Brad DeLong, among others, makes an excellent case that even a trillion dollar stimulus would have only a tiny effect on the federal government's future solvency. So even if a big stimulus has little positive effect -- which seems unlikely given current circumstances -- it doesn't create much danger either. So why not try it? The fiscal purists sure don't seem to have much in the way of better ideas.

When put into the context that under Bush, the deficit exploded and the same folks who are screaming about deficits were absolutely silent only 5 years ago, you know that this argument is really only about political power. There's the perception that short-term deficits are a problem, when the true issue is the effect that our long-term deficits will have on economic growth, which neither Krugman nor De Long deny:

We do have enormous long-run deficit problems. They are not the result of any future difficulty in paying off what we are borrowing today. They will be the result of the enormous medical care spending that we have put in train for the 2020s, 2030s, and 2040s. To wonder how we will pay off the debt we are currently accumulating is to fundamentally misunderstand the situation we are in.

So to re-cap: short-term deficits = good; long-term deficits = bad. In the extremely dicey economic situation we find ourselves, the short-term issues outweigh - by far - the long-term structural deficit issues.

It might be too late, though, since it seems like the deficit hawks are winning the argument.

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