Referring back to yesterday's post about CIT Group facing collapse, CIT Group is important right now because it is one of the few sources of short-term credit for businesses. In spite of the government TARP assistance or even after returning the TARP money, banks are not making loans. Maybe they have rightly concluded that the potential clients are in fact poor risks in this economy. This is part of the reason why CIT is in trouble; their loan clients have been defaulting.
Even for very simplistic business models you can see how a restaurant, for instance, would need credit to pay for this month's supplies and maybe even employee salaries in order to be open for business and make money. I suppose they could save up a cash buffer first before starting (probably some economic arguments for why this is unlikely) but in the real world this is not the reality. So if CIT goes away, things like restaurants and retailers go out of business very quickly (I would guess within a month or so). This means many more people unemployed and further reduced revenues for cities, counties, and states; in short, continued severe economic contraction.
So Paul Krugman is right, at least in the strictly mechanical sense of how our economy works: we really do need more money quickly thrown into the system to keep this from happening. The Fed is powerless to do this since interest rates are already zero, so options like the government stimulus are about all we have. If the money is not provided, I guarantee that we will see the great economic contraction; it is like a law of physics applied to our economic system.
Where I part with Krugman is on whether it is desirable to keep the system going. If it is, then it doesn't matter if the stimulus money does anything useful or not. Keynes made this point blatantly when suggesting the benefits of burying bottles of coins in the ground so mining companies could dig them up, providing jobs and profits. The whole idea is that any kind economic activity and available credit will get the system moving again so it can return to its former task of doing useful work and providing value. Our problem, as I have pointed out before, is that our system was not doing useful work or providing value even before it seized up, and the changed global economic environment makes returning to that previous model impossible anyway.
Since a further stimulus seems politically impossible, we should expect economic contraction.
A third way would be to scrap the former economy and start designing a new one. We would still have the contraction, so people would have to be basically kept alive during this period by massive government direction and intervention. There is no way to avoid this anyway, before too long social services will start to be stressed to the breaking point by the large numbers of unemployed. But if we are intentional about it we could do useful work towards the new economy while meeting these needs.