Out of the Liquidity Trap?

Professor Krugman has produced an interesting graph that — according to his calculation — suggests that while we’re not quite out of the liquidity trap, we are getting closer:

It’s a useful contribution, that shows just what the Federal Reserve does in terms of trying to match interest rates to the broader inflationary outlook. The liquidity trap at the zero bound is clearly visible — the Fed cannot cut rates below the zero bound, which renders traditionally monetary policy essentially useless. (Austrians will of course interject here that traditional monetary policy is worse than useless, but that is another story for another day).

If the liquidity trap is ended, we should eventually see higher demand (Krugman’s point is broadly that stimulus would fight off the problem of the liquidity trap and solve the problem sooner). The Krugmanites think that demand is the only problem, and higher demand (even if that is down the line and later than Krugman would like it) will cure our economic woes.

I completely disagree and believe that depressed demand is not the main problem, but merely a symptom. I believe that the credit contraction that occurred in 2008 was a direct product of various non-monetary challenges that America faces, almost none of which have been solved, or will be solved by an end to the liquidity trap:

The three main problems are a lack of confidence stemming from high systemic residual debt, deindustrialisation in the name of globalisation (& its corollary, financialisation and that sprawling web of debt and counter-party risk), and fragility and side-effects (e.g. lost internal productivity due to role as world policeman) coming from America’s petroleum addiction.

In the months and years to come we will see who is right.

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