Thursday, January 22, 2009

Liquidity Trap

Here is material by Bruce Bartlett on Brad DeLong's blog that is a pretty good economics primer. Reading this will help you understand what is unique about the current recession and it is an excellent presentation of why the US economy is in a "liquidity trap". I've bolded key bits:
... A study by Obama administration economists Christina Romer and Jared Bernstein predicts that the stimulus plan being debated in Congress will raise the gross domestic product by $1.57 for every $1 spent.

Such a multiplier effect has been heavily criticized by a number of top economists, including John Taylor of Stanford, Gary Becker and Eugene Fama of the University of Chicago and Greg Mankiw and Robert Barro of Harvard. The gist of their argument is that the government cannot expand the economy through deficit spending because it has to borrow the funds in the first place, thus displacing other economic activities. In the end, the government has simply moved around economic activity without increasing it in the aggregate. Other reputable economists have criticized this position as being no different from the pre-Keynesian view that helped make the Great Depression so long and deep....

I think the critics of an activist fiscal policy are forgetting the essential role of monetary policy as it relates to fiscal policy. As Keynes was very clear about, the whole point of fiscal stimulus is to mobilize monetary policy and inject liquidity into the economy. This is necessary when nominal interest rates get very low, as they are now, because Fed policy becomes impotent. Keynes called this a liquidity trap, and I think there is strong evidence that we are in one right now. The problem is that fiscal stimulus needs to be injected right now to counter the liquidity trap. If that were the case, I think we might well get a very high multiplier effect this year. But if much of the stimulus doesn't come online until next year, when we are likely to be past the worst of the slowdown, then crowding out will greatly diminish the effectiveness of the stimulus.... Thus the argument really boils down to a question of timing. In the short run, the case for stimulus is overwhelming. But in the longer run, we can't enrich ourselves by borrowing and printing money. That just causes inflation...

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