To go along with Frank’s excellent piece today, we have (Who else?) Paul Krugman — excuse me, Nobel Laureat Paul Krugman — declaring that we are in a “liquidity trap” and that the only way out is for the government to spend money that it does not have.
The Newly-Anointed One (not to be confused with the “Anointed One” who will be elected president on Tuesday) declares:
… consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.
Some background: one of the high points of the semester, if you’re a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone’s income.
In fact, consumers’ income may actually fall more than their spending, so that their attempt to save more backfires — a possibility known as the paradox of thrift.
The cure? It is (drum roll) Government Spending!!
For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It’s true that Ben Bernanke hasn’t yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it’s hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.
The capitulation of the American consumer, then, is coming at a particularly bad time. But it’s no use whining. What we need is a policy response.
The ongoing efforts to bail out the financial system, even if they work, won’t do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we’ve seen, Americans were overextended even before banks started cutting them off.
No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.
The one fear that Krugman has, not surprisingly, is that the “free market” Bush administration will block this action:
Let’s hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let’s also hope that the lame-duck Bush administration doesn’t get in the way.
There is one fallacy after another in this column, and I wish I had the time to debunk all of them, but Henry Hazlitt beat me to it nearly 50 years ago, with his classic The Failure of the New Economics. It is time to give this great volume another look.