Nobel Prize Winner's Recession Solution

Nobel Prize-winning economist Paul Krugman said the government could borrow up to $5 trillion -- if needed -- to speed up a recovery from the recession.

A stimulus plan of that size is probably not needed, but Krugman said he believes the $775 billion proposal from President-elect Barack Obama isn't big enough.

"We're not in a depression. But we are in a situation where the normal tools don't work and we're back to 1930s-type environment," Krugman said in an interview with ABC News. "Government spending is the only surefire way to create employment."

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"I hope that things will be improving by 2011, but they will still be ugly," Krugman said. "It's nasty. This is nasty, brutish and long. It's really going to go on for an extended period, even with the best policies. And it's not clear if we are going to have the best of policies."

When asked what he would spend the money on, Krugman said it's not up to him to name specific projects but that they should quickly create jobs and create a lasting improvement in the economy.

"I've been impressed with people who are talking about upgrading the rail system for freight," Krugman said. "Freight rail is a success which is hindered by small but extreme bottlenecks. So that's an example of a kind of project that would spend money but also provide a lot of long-term benefits to the economy.

"The fastest and most effective way to spend money is to avoid cutbacks," he added. "And aid to state and local governments looks like a really productive use of funds."

See Krugman and other economists talk about the recession on "World News" Friday at 6:30 p.m.

Krugman, who is a professor of Economics and International Affairs at Princeton University and a columnist for the New York Times, did not say how large the stimulus plan should be, but has said it is better to spend too much than not enough.

"At max, the U.S. government can probably borrow another $5 trillion," Krugman said. "Hard to believe, but we can probably get away with that if we have to. I hope we don't have to spend that much."

Krugman's Analysis of the Economy

Krugman, a well-known liberal, said the situation is at least as difficult technically "as the problems that [President Franklin D. Roosevelt] faced in 1933 in a world moving a lot faster than we had in the 30s."

The massive scale of the problem creates its own kind of political tightrope walking.

"Obama's going to have to deliver some results in a way politically, if not economically," Krugman said. "If he's got a stimulus program that's helping the economy, it will be easier to say: and we also need to help the banks. If nothing seems to be working, the public might just say, 'Hell no, we don't want to do any of this.'"

Krugman said he does not support tax cuts for businesses, saying such an approach would do little to help the overall economy.

One of the most controversial parts of the Bush administration's plans to help the economy to date has been the billions of dollars given to banks and other financial institutions.

"There need to be more strings attached. Part of the problem is: we backed into this massive socialization of finance in the hands of an administration that basically didn't believe that the government should be dictating anything. So there have been very few strings attached," Krugman said. "One hopes that with the remainder of the bailout money, that it will be used with strings attached. That there will be demands that the banks have to do more with the money."

That said, Krugman noted that "we're not just handing them checks."

"We're actually buying shares. So, you, the public is getting an ownership stake in the banks," he said. "Were not going to make money on this thing, but it doesn't cost quite as much as it looks like."

That message hasn't been conveyed properly to the public and "there is a real problem of trust."

"We need some fireside chats, or whatever the YouTube equivalent is, from the new president to convince people that we are, in fact, having policy in the public's interest," Krugman said.

How to Fix the Economy?

There is one bright side to this mess.

"I say thank God we did not privatize Social Security; the one rock of our retirement system that is still there. At least we have that. It's a reminder that's it's a good policy introduced 70 years ago," Krugman said. "People have lost their portfolios. There's not much Uncle Sam or anybody can do about that."

To solve the problem, Krugman said, the administration needs "to move fast and massively."

"My great fear is not that we're going to fall into a Great Depression in the next year," he said. "My fear is that we're going to have a lingering, major slump for two, three years."

So what can be done to fix the economy?

Letting home mortgages be treated the same as other debts in bankruptcy is something Krugman favors because it "will give lenders a very strong incentive to renegotiate, to help people get their mortgages down."

"There's only so much you can do," he added. "If somebody bought a house that's really twice what they can afford, no process on Earth is going to make this thing work."

But by reducing some people's mortgages, it will help the economy, he said, "and it will also create a little bit more sense of justice here that we're helping real people here, not just Wall Street."

Americans aren't panicking, Krugman said, but finally becoming rational.

"And that's the problem," he said. "People have been living in a dream world for a couple of decades and now they're suddenly saying they should start saving for retirement and that's very difficult to deal with."

Krugman describes the realization of the current crisis as a "Wile E. Coyote moment." For years, we had been supporting our economy on a housing bubble. Then one day, Americans woke up and realized that our homes weren't worth what we thought and we fell off the cliff.

"Now, we basically have to gradually climb back up the cliff. We can't walk on air," he said. "Over time, we need to build an economy on more solid stuff: actual exports, producing stuff, not just moving assets back and forth."

So what is Krugman's financial advice for Americans?

"They should be doing exactly what is creating the problem for the economy, which is save more, put more money aside, don't take big risks … I can't in good conscience give other advice. That's what people need to do."