From his Nobel AEA meeting lecture.

It should have been easy to put the evidence of a mammoth housing bubble together with the concepts of third-generation crisis theory to see how a nasty deleveraging cycle could occur without the “original sin” of dependence on foreign-currency debt.

Sadly, almost nobody – certainly not yours truly – put the pieces together.

Thanks to Mark Thoma for the pointer.

Basically, Krugman’s story is that the U.S. experienced something like a currency crisis, except that our debts are denominated in our own currency. In a classic currency crisis in another country, that country had debts denominated in dollars. It suffered increases in real debt costs as its currency depreciated, but the increase in net exports helped restore total demand.

On the other hand, the asset-price deflation that Krugman posits as being the heart of our crisis has no compensating stimulative effect. However, by the same token, it seems to me that if our currency were to depreciate, we would have the demand stimulus of greater net exports without the contractionary impact of raising the real cost of our debt. So I am not convinced that we are somehow in a worse position because we are experiencing asset-price deflation rather than a currency crisis.

Like Scott Sumner, Krugman views the main problem as deflationary expectations. I am not sure where these expectations come from. In Sumner’s story, people just decide that the monetary authority is willing to see the price level drop. In Krugman’s story, the process of de-leveraging in housing triggers an overall self-fulfilling drop in inflation expectations.

Krugman’s forecast is for a Japan-like slump. In contrast, the Recalculation Story suggests that we could have stagflation, as the efforts to pump up demand run up against the reality that the necessary reallocation of labor takes time. My guess is that by the middle of 2012, we will see an unemployment rate of about 7 percent and an inflation rate of 5 percent. My sense is that Krugman thinks that the unemployment rate may well be higher and the inflation rate will certainly be lower.