At the core of ours crisis is a bet.
The bet is a simple one: that revenues will grow, in the long term, in such a way as to enable governments to finance their debt.
Much of modern finance is all about cash-flow and leveraging that cash-flow to create the greatest value with the smallest risk. This is true for corporations, it's true for governments and it is true for private persons as well. Corporations use their cash-flow to finance loans for expansion; governments use their cash-flow to finance bonds to pay for politically mandated consumption and investment; private person use their cash-flow to finance house purchases and other big-ticket items.
Fundamentally, it's all fine as long as the cash-flows continue, the business plans unwind, the mortgages are paid It goes all wrong when the business plans stumble, when governments permanently expand spending at a fast rate than the economy grows, and when someone loses their job.
Unfortunately, we've all been getting it rather wrong.
The reason? Lack of recognition that there is risk out there. It is naive for a private person to leverage their incomes to the extent that if they lose their job - something completely out of their control - they will also lose their ability to finance debt via cash-flow. For mortgages there is insurance available for such an event, but not all debt is mortgage debt, and indeed it's a rather high cost (since it only gives additional playing room to find a new job, not to pay off your mortgage in its entirety: if it were the latter, it would be prohibitively expensive), for other debt instruments it's not so simple. Risk, after all, don't merely exist for the banks: for the private consumer, it is a catastrophe if their entire life style is based on leveraging their cash flow heavily. The same is true for companies: business plans generally are expected to unwind smoothly, but usually fail to take into account the fact that they are expected to do this in the future, resulting in companies failing when their business plan stumble and the companies are heavily leveraged and dependent on that cash-flow being generated. Governments rely on their economies to grow at least as fast as government spending increases so that revenues continue to flow such that government bonds can be repaid and debt rolled over.
Boy, are we getting it wrong.
The result? A fiscal straitjacket, regardless of corporate, government or private. Debt that can no longer be financed out of cash-flow has, given the demand for risk compensation in the form of interest rates, this nasty tendency to accelerate and continue to accelerate. At some point the debt cannot be paid back, especially if the crisis that led to the stumbling of the business plan, the loss of a job or an upswing in deficit spending doesn't go away quickly.
Krugman may actually have something right (if for the wrong reasons): we have reached a point where we are starting to enter a long depression, where debt burdens crush growth because profits have to be used to pay off debt rather than be used for other purposes.
Where he is horribly wrong is his call for continuing massive increases in government spending to get us out of the crisis.
Were that times were so simple as in the era of Keynes. He correctly identified that economies go into recessions, for one reason or another (for Keynes it is the stagnation of worker's wages) and that governments can work against the recession by spending money.
If, of course, the governments weren't already carrying punishing levels of debt that, if increased, would result in the necessity of default.
That is, however, the problem: hence Krugman is completely and horribly wrong to demand that government spending generate growth. He is horribly wrong because the government is, now, at the point where it is slowly starting to notice the straitjacket that it has placed itself in: with the cost of money virtually nil, governments have acquired debt such that if interest rates rise, the debt almost immediately becomes unsustainable and default occurs.
People are put into straitjackets to prevent them from hurting themselves and others. Corporations and businesses who find themselves in dire straits impoverish their owners, either via bankruptcy or legal requirements to supply the needed capital; governments default on their sovereign debt.
You cannot apply Keynes' solutions to recession when government debt is already in dire straits because politicians leveraged the government's cash flow so heavily that any growth slowdown destroys the game plan: this is exactly what has happened over the last, oh, 40 years or so.
The sooner that a house-owner realizes that they can't pay their mortgage because an income stream was lost, the easier it is to do something about it, be it jingle mail, mea culpa and refinancing with the mortgage issuer (I first wrote "bank" here, but given the lack of bank involvement nowadays, it's the mortgage issuer...), or life-style changes to prevent bankruptcy.
The sooner that a company realizes that the business plan isn't working, the cheaper it is to cut your losses and close that business unit down, or to re-do the business plan to save the business.
The sooner that the government realizes that government spending is unsustainable, the easier it will be to make changes in entitlements, cut discretionary spending and, even, raise taxes to get government debt back under control and within a new, changed revenue stream.
Instead, we see folks like Frank and Dodds re-arranging the deck chairs on the Titanic that is government spending in the US. Their failure?
To think that it's business as usual and that nothing needs to change: failing to recognize that there is a need to change is sheer and utter insanity, the kind that leads to straitjackets.