The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.
Some say the worst is already over. Mr. Greenspan, who's been an optimist all the way, now argues that the latest data on new-home sales and mortgage applications suggest that housing has already bottomed out. Business investment is still growing briskly, and so far consumers haven't cut their spending. So maybe this is as bad as it gets.
But I think the pessimists have a stronger case. There's a lot of evidence that home prices, although they've started to decline, are still way out of line. Spending on home construction remains abnormally high as a percentage of G.D.P., because banks are still lending freely in spite of rapidly rising foreclosure rates.
This means that home sales probably still have a long way to fall. And you don't want to make too much of the fact that some housing indicators have turned up; those indicators tend to bounce around a lot from month to month.
Moreover, much of the good news in the latest economic report is unsustainable at best, suspect at worst. Almost half of last quarter's estimated growth was the result of a reported surge in automobile output, which some observers think was a statistical illusion, not something that really happened.
So this is probably just the beginning. How bad can it get? Well, you don't have to go far to find grim forecasts: Merrill Lynch predicts that the unemployment rate will rise from 4.6 percent now to 5.8 percent by the end of next year.
In case you're wondering, I don't blame the Bush administration for the latest bad economic numbers. If anyone is to blame for the current situation, it's Mr. Greenspan, who pooh-poohed warnings about an emerging bubble and did nothing to crack down on irresponsible lending.
Update: Like commenter David Clayton below, I recommend that readers read Krugman's whole 2002 article. I think my interpretation, that he was saying a bubble would be a good thing, holds up to scrutiny.
Update 2: More advocacy from Krugman
KRUGMAN: I think frankly it's got to be -- business investment is not going to be the driving force in this recovery. It has to come from things like housing, things that have not been (UNINTELLIGIBLE).
DOBBS: We see, Paul, housing at near record levels, we see automobile purchases near record levels. The consumer is still very much in this economy. Can he or she -- or I should say he and she, can they bring back this economy?
KRUGMAN: Well, as far as the arithmetic goes, yes, it is possible. Will the Fed cut interest rates enough? Will long-term rates fall enough to get the consumer, get the housing sector there in time? We don't know. [italics added.]