Elephant Shit

SYNOPSIS: Apparently economic commentator Don Luskin has never heard of the liquidity trap. This piece is a companion to this one and this one and this one and this one, and this all comes back to some critics' false accusations of arithmetic problems in Krugman's 4.22.03 NYT piece.

Thanks to Bobby Pelgrift at the  unofficial site I've been led to  Demosthenes (GREAT blog name, by the way - does Orson Scott Card know? And where's Locke?), where I learn that my stalker-in-chief thinks that the liquidity trap is "elephant shit". The purpose of this note is to remind everyone that this is very serious shit indeed.

Just an aside: as Demosthenes notes, it is bizarre that someone who claims to have insight into economics has apparently never heard of a liquidity trap. It's even more bizarre that someone who spends a lot of time attacking yours truly doesn't know that this is one of my signature academic issues. Also, doesn't some version of Godwin's law apply here - the first person to mention bodily wastes loses the argument?

Anyway, let me explain why everyone concerned with economics should know about liquidity traps.

If there is one key promise of modern economic policy, it is that we won't have a repeat of the 1930s. And we have been confident that we could, in fact, avoid such a repeat. Friedman and Schwartz showed that the Great Depression was associated with a big contraction in the money supply; their implication was that as long as we have a central bank that prevents such a monetary collapse, we're safe. More broadly, we count on central banks to stabilize the economy, preventing excessively wide swings in output and prices.

But what if there are conditions under which the central bank loses traction? In the 30s and well into the 50s many economists thought that such conditions were quite likely - they thought that it was quite possible that a central bank fighting a recession would drive interest rates close to zero, and that any further monetary expansion would simply be stuck away in mattresses or in bank vaults, doing nothing more for the economy. As I pointed out in an earlier  post , this view was alive and well in Samuelson's original 1948 textbook.

By the 1990s, however, the liquidity trap had largely (though not entirely) vanished from economic discussion. The Fed had demonstrated its power in ending recession after recession; there seemed no reason to doubt that it could always do so at need.

Then came Japan, which by 1996 looked an awful lot like a country in a classic liquidity trap. And that was scary: it meant that our grandfathers weren't as stupid as we thought, that 1930s-style slumps may not be that easy to cure, after all. Or as I put it a couple of years later, it was as if a disease we had thought controlled had reappeared in a form resistant to all the usual antibiotics.

At first I didn't believe it; in early 1998 I set out to write down a fully worked-out, no loose ends model to show that liquidity traps can't really happen. (The purpose of such a model is to help you think clearly about an issue - realism is not the point.) To my surprise it showed that liquidity traps can indeed happen;  Japan's trap was real. And Japan remains stuck in that trap.

That in itself makes the liquidity trap a very important subject: Japan is the world's second-largest economy, and not that long ago seemed to be the economy of the future. But there was obviously more. If it could happen to Japan, why not to us? As the US bubble of the 90s grew to rival that of Japan in the 80s, one couldn't help wondering whether we might see a similar aftermath.

Sure enough, here we are, Fed funds at 1.25, with an economy still losing jobs. We hope that things will pick up, that a year from now this will all seem like a bad dream. But at the very least we're having a serious scare.

And do I need to point out that the case for fiscal policy to create jobs rests mainly on the fact that the economy is near a liquidity trap? If the interest rate were currently 5 percent, we'd all say that the Fed needs to cut more, while the Treasury and the Congress should focus on long-term fiscal responsibility. It's the Fed's possible ineffectuality that makes us reach for another tool.

So here's the straight poop: the liquidity trap isn't some exotic concept, of interest only to econo-nerds. It's central to understanding the top economic issues of our time.

Originally published on the Official Paul Krugman Page, 5.5.03