SYNOPSIS: Krugman discusses our prospects in our first recession caused by a bubble rather than the FED

DOBBS: OK, Tim. Tim O'Brien from Washington. Chairman Greenspan today noted what he termed the "quiescence of inflationary pressures." His statement borne out in one economic report released before his testimony this morning. The Consumer Price Index up .2 percent in June. When you take out food and fuel it gained .3 percent. Both were slightly higher than expected, but as one economist put it today there's no major worry here. And housing starts jumped 3 percent last month. That was stronger than most economists had expected and it is further evidence of some strength in the industry. The gain in June follows a modest decline in May. The bond market today seemed to focus more on the tame inflation than the cautious talk from Greenspan. The 10-year gained 28 ticks, the yield 5.08 percent. The 30-year bond soared more than a point in price and the yield, 5.5 percent. Amongst the questions now: What will the Fed do next? The latest survey by Reuters found that all 25 bond dealers polled believe the Fed will cut rates next month by a quarter point, up from 23 before Mr. Greenspan delivered his testimony. Joining us now with his view on the Fed chairman's comments, the outlook for the economy and his own view of where we should be going, Paul Krugman, columnist for "The New York Times." Paul, good to have you with us.

PAUL KRUGMAN, ECONOMIST, PRINCETON UNIVERSITY: Good to be on.

DOBBS: The Fed chairman seemed uncharacteristically direct talking about this economy?

KRUGMAN: I do wonder what got into him. I think the quick summary today is Greenspan says, I'm not God, and the Nasdaq falls 50 points on the news. It was kind of an amazing day.

DOBBS: And the fact that the door is now open to another interest rate decline, that obviously is a hopeful sign to most investors. But the fact is we haven't seen much impact from 6 interest rate cuts in six months.

KRUGMAN: Right, the impact is in what hasn't happened, instead of what has, which is that this has not turned into a freefall in the economy unless you happen to be a tech firm. But the Fed is certainly having harder time turning this around than we have become accustomed to have happen.

DOBBS: Greenspan pointed out that he is very hopeful because of three major factors. One, lower energy prices, second, lower interest rates, and thirdly the tax rebates coming from the Bush tax cut that will start hitting mailboxes next week. Does that also salve your concerns?

KRUGMAN: I'm nervous as I think he is. You know, all of the major recessions we've had for the last 40 years have been basically caused by the Fed. It was the Fed raising interest rates to bring inflation down. And this one, although the Fed did a little of that, is basically the first one we've seen in generations that was caused by a bubble in the private sector. It was caused by overinvestment. And it's somewhat an uncharted territory here. We don't know how much Fed cutting it takes.

DOBBS: To restimulate business investment, capital investment and corporate buying?

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.

DOBBS: Your column today, you talked about Keynesian economics and how we've become adopters, if in denial, of it, adopters of Keynesian thinking, and our economic policy. How could you be so cynical?

KRUGMAN: No, I mean, look, it -- is anybody saying for the U.S. economy, Greenspan is wrong to try prevent the recession? We should have the recession, we should purge. The budget isn't as good as we thought. We should raise taxes, which are all of the things of course that we tell countries like Argentina. But for ourselves, no, we believe in cushioning ourselves from these things.

DOBBS: We do have a surplus, at least to work with. I know you don't think it's...

(LAUGHTER)

DOBBS: That's a whole other program.

KRUGMAN: Yes, that's another bit of a (UNINTELLIGIBLE).

DOBBS: Paul Krugman, good to have you with us.

KRUGMAN: Good to be on.

DOBBS: CNN's parent, AOL Time Warner, today reported quarterly results. While earnings did beat estimates, revenues fell short of expectations. But a bigger concern on Wall Street, the company's cash flow. Fred Katayama has the story.

Originally broadcast, 7.18.01