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Krugman contra Hayek

Mises Daily: Thursday, July 29, 2010 by


The current recession has brought back discussion on the merits of countercyclical fiscal and monetary policy. Broadly speaking, the economics profession is divided into two camps. One side is made up of "liquidationists" and "deficit hawks," supporting tight monetary policy and low — or no — government spending. The other group is composed of those fearing a fall in prices, who support easy credit and expansive fiscal policy to combat it. While most economists probably fall in between, this dichotomy represents the two poles. The extremes are occupied by the Austrian School on one end and Paul Krugman on (or close enough to) the other.

The growth of the Austrian School has forced economists like Paul Krugman — who, for the sake of simplicity, we will refer to as Keynesians[1] — to reconsider these opposing viewpoints. Krugman originally addressed Austrian business-cycle theory in 1998 and since then has continued to provide criticism.[2]

A recent contribution to the debate, "Antipathy to Low Rates," swipes at Friedrich Hayek's "liquidationism." The argument Krugman makes is that those who disapprove of countercyclical quantitative easing and fiscal policy inevitably support a long period of depression, and thus equally "persistent" high unemployment.

Krugman bases his antiliquidationism thesis on the following passage written by Hayek and quoted by Bradford DeLong in a as of yet unpublished history of economic thought in the 20th Century,[3]

still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand[,] resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed. The only way permanently to 'mobilise' all available resources is, therefore to leave it to time to effect a permanent cure by the slow process of adapting the structure of production.[4]

Krugman then provides his interpretation,

These days, relatively few economists are willing to say straight out that they regard persistent high unemployment as a good thing. But they find reasons to oppose any and all suggestions to use government policy — including monetary policy — to alleviate the slump.

While Krugman's position is erroneous, regarding both fiscal and monetary policy, it is important to understand Krugman's exact argument. The concept of the liquidity trap is the keystone to Krugman's thesis,[5] according to which the rules of the game change when there is a lack of private investment.[6]

As a general concept, the liquidity trap is legitimate in the sense that we are currently in a situation in which, despite the extreme provision of liquidity on the part of the Federal Reserve, there has not been a substantial increase in real private investment. As such, any Austrian rebuttal to Krugman should concede this point.

The real debate is whether or not fiscal stimulus can effectively revive an economy (or pull it out of a "liquidity trap") or if fiscal stimulus contributes to the existence of a liquidity trap — there is the distinct possibility that this so-called liquidity trap is the product of regime uncertainty, which may or may not be aggravated by government policy.

All considered — even conceding that we are in what Krugman would call a liquidity trap — within the Misesian-Hayekian framework, the only permanent solution to existing malinvestment is to allow its liquidation and the readaptation of the structure of production.

This suggests — like Krugman accuses — that following a boom of malinvestment there will be a period of relatively high unemployment. Krugman would temporarily alleviate the fall in employment and production through public expenditure; however, the problem with loose fiscal policy is that government cannot distribute and invest capital efficiently or profitably. Furthermore, government countercyclical policy tends to create regime uncertainty, which may directly contribute to the existence of this "liquidity trap."

Brief Overview of the Keynesian Liquidity Trap: From Keynes to Krugman

The concept of the "liquidity trap," a term coined by economist Dennis Robertson,[7] has returned to the forefront of Keynesian economic analysis. While Krugman's liquidity trap bears the same name as that of Robertson, Hicks, and Keynes, Krugman's liquidity-trap theory is fundamentally different.[8] In general, however, all liquidity-trap theories are meant to detail the limitations of monetary policy and the advantages of fiscal policy.

"Within the Misesian-Hayekian framework, the only permanent solution to existing malinvestment is to allow its liquidation and the readaptation of the structure of production."

While the liquidity trap does not play an important or major role in Keynes's General Theory, there is a mention of it in the fifteenth chapter of the Keynesian magnum opus,

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest.[9]

Keynes believed that such a situation occurs out of a change in the "state of expectation."[10] In other words, an increase in uncertainty leads to an increase in the demand to hold money and a decrease in investment,[11] based on the belief that money's relatively riskless qualities makes it more desirable to hold than bonds and assets.[12] Given a "virtually absolute" liquidity preference, monetary policy becomes ineffective at stimulating "aggregate demand" since an increase in the supply of money cannot increase wage-earners' incomes.[13] Furthermore, even supposing a fall in the "pure rate of interest," Keynes argued that monetary stimulus cannot diminish the cost of lending, and therefore moneylenders are unwilling to lend under a certain rate of interest.[14] Keynes's solution to such an event is government spending.[15]

While Keynes provided the groundwork, it was John Hicks who refined the theory within the bounds of what was to become known as the Investment-Saving/Liquidity Preference-Money Supply (IS/LM) model. Hicks originally formulated the IS/LM in 1937, in "Mr. Keynes and the Classics,"[16] and later elucidated it in his 1939 book Value and Capital. Hicks believed that while monetary policy could check an increase in the price inflation by increasing the rate of interest, the central bank is effectively unable to stop price deflation[17] because of the positive floor to the interest rate — which prohibits newly created money from being introduced into circulation.[18]

Hicks also introduced key differences to interest rate theory, contra Keynes, including putting emphasis on the idea of the elasticity or inelasticity of the long-term rate of interest based on expectations.[19] Writes Hicks,

If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall. This does not only mean that the long rate must be a sort of average of the probable short rates over its duration, and that this average must lie above the current short rate. There is also the more important risk to be considered, that the lender on long term may desire to have cash before the agreed date of repayment, and then, if the short rate has risen meanwhile, he may be involved in a substantial capital loss. It is this last risk which provides Mr. Keynes' "speculative motive" and which ensures that the rate for loans of infinite duration (which he always has in mind as the rate of interest) cannot fall very near zero.[20]

After receiving much attention from the likes of Nicholas Kaldor,[21] Franco Modigliani,[22] and Lawrence Klein, Hicks's IS/LM formulation of the liquidity-trap theory became the standard Keynesian representation.[23] Between 1940 and 1970, the liquidity-trap theory went through major changes and reformulations, only for Hicks to recant, suggesting that, "[w]hile one can understand that large balances may be held idle for considerable periods, for a speculative motive, it is harder to grant that they can be so held indefinitely."[24]

The prominence of liquidity-trap theory in mainstream macroeconomics began to rescind by the early 1970s. A change in focus in macroeconomics factored into this shift in thought,[25] as did high rates of interest throughout the 1970s and 1980s that made the idea of a liquidity trap largely irrelevant.[26] Furthermore, research by Milton Friedman and Anna Schwartz questioned the belief that the Great Depression was beset by a liquidity trap,[27] denying the Keynesian camp from any clear empirical evidence supporting their position.[28]

Interest in the liquidity trap resurfaced when Paul Krugman applied his own version of the concept to Japan's economic stagnation of the 1990s. Krugman explains that

[a] liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible price, full-employment economy; and although any reasonable model of the United States in the 1930s or Japan in the 1990s must invoke some form of price stickiness, one can think of the unemployment and output slump that occurs under such circumstances as what happens when an economy is trying to have deflation — a deflationary tendency that monetary expansion is powerless to prevent.[29]

Where Krugman parts ways with Keynesian precedents is in applying a theory of intertemporal expectations, where monetary policy is ineffective because of the expectation of future deflation — the public believes monetary policy to be only temporary, as opposed to sustained.[30] In effect, expectations of future deflation cause individuals to shift time preference: they prefer holding cash to investment, believing that in the foreseeable future the value of said cash will rise. As such, injections of liquidity have no impact on present aggregate demand.[31] Note, Krugman is not arguing that monetary policy is temporary, only that the public perceives it to be temporary. Krugman cites two reasons why: the public's knowledge that the Bank of Japan was unwilling to allow for a radical depreciation of the Yen, and its reputation for maintaining price stability and low inflation.[32]

There are two general "New Keynesian" solutions to Krugman's liquidity-trap problem,

  1. Expansionary fiscal policy;
  2. Expansionary monetary policy targeting for long-term inflation.

The case for fiscal policy claims that a sufficiently large temporary fiscal stimulus to the economy would "jolt" the economy towards equilibrium, by increasing output and aggregate demand,[33] where expansionary monetary policy would once again be effective.[34] Krugman cites the Second World War as an example and writes that "the massive one-time fiscal jolt from the war pushed the economy into a more favorable equilibrium."[35]

Writing in support of deficit spending, Bradford DeLong puts it much more crudely, stating that "at this point, anything that boosts the government's deficit over the next two years passes the benefit-cost test — anything at all."[36]

While Keynes and Hicks would have perhaps shied away from massive monetary stimulus, operating with the understanding that monetary policy was ineffective during a liquidity trap, New Keynesian theory puts much more importance on a growing money supply. In fact, Krugman's monetary solution to a liquidity trap is sustained inflation, where the central bank reverses fears of future deflation by instead causing an increase in the price level through massive monetary pumping (Krugman estimates this to be in the area of $10 trillion, borrowing the figure from a prior study conducted by Goldman Sachs).[37] Periods of relatively high inflation would not be temporary, as to assuage fears of future deflation. Instead, the "optimum" monetary policy is one that targets relatively high inflation for a period long enough to shift the public's rational expectations.[38]

As is, the Keynesian "solutions" to a liquidity-trap run in the face of Austrian capital and calculation theory. The idea that government investment is as good as private investment is highly suspect, while a policy of monetary inflation is bound to lead to malinvestment. Thus, the Austrian capital and business-cycle theory are highly relevant. Understanding the Keynesian argument, we can now delve into Hayek's work.

Austrian Economics and Economic Restructuring

Although Austrian business-cycle theory is not simple — especially since it is rooted in a wealth of capital and monetary theory developed by a multitude of economists[39] — it can be concisely explained as a theory that recognizes disequilibrium between savings and investment.[40]

The relationship between consumption, saving, and investment is intertemporal in the sense that in order to accumulate the capital necessary to invest one must refrain from present consumption and opt for future consumption.[41]

This intertemporal relationship between consumption and investment is reflected through the interest rate, which serves as a price mechanism, transmitting information to the entrepreneur. An increase in savings, or a societal shift towards the preference to refrain from present consumption, leads entrepreneurs to borrow these savings and invest them to satiate the needs of these savers in the future. Austrians call this a lengthening and a widening of the structure of production, as entrepreneurs invest in stages farther away from the final consumer good.[42]

Given that the rate of interest reflects society's time preference — or preference towards present or future consumption — it thus acts as a mechanism by which savings and investments strive to reach equilibrium (or where the two are equal).[43] Disequilibrium would therefore imply that savings are unequal to investments, or, in other words, that the market is not acting according to society's time preference. Instead, a disequilibrium caused by credit expansion lowers the rate of interest, makes capital-good investment more lucrative,[44] and thusly lengthens the structure of production without a prior increase in savings.[45] In this case, an increase in investment is not met by an equal decrease in consumption, and so investment outstrips savings.

The productive boom, caused by this disequilibrium, must inevitably end when the price mechanism adjusts — or when the credit boom ends.[46] The structure of production is now pressured to return towards equilibrium.

"The idea that government investment is as good as private investment is highly suspect, while a policy of monetary inflation is bound to lead to malinvestment."

Despite this notion of disequilibrium, Austrian theory does not argue in favor of blaming "overinvestment," as the supply of capital goods does not necessarily increase. Instead, it examines price distortion where a price ceiling is effectively installed causing entrepreneurs to not recognize the actual scarcity of the capital goods in question — the adjustment of the price mechanism reveals this scarcity, and entrepreneurs must liquidate their "malinvestments."[47]

Knowing where Hayek was coming from makes his comment, as quoted by Bradford DeLong and Paul Krugman, far more understandable. The depression period is one in which the structure of production readjusts according to society's time preference, and so the most sensible approach to returning to economic stability is allowing this readjustment to take place the fastest possible.

One of the results of this readjustment is a fall in the supply of money — what Austrians refer to as deflation. There are three main reasons this occurs,[48]

  1. A rise in demand for money, or a rise in demand for liquidity, in expectation of falling prices;[49]
  2. Credit contraction due to a reduction in outstanding loans by banks fearing bankruptcy, or predicting a greater need for liquidity;
  3. A fall in outstanding credit and loans caused by default or liquidation of malinvestment.

The common Keynesian argument is that of the "deflationary spiral." Finding its modern origins with Irving Fisher,[50] this argument suggests that a fall in prices makes it more difficult for debt to be repaid, increases demand for money, and feeds on itself in the sense that it causes a cycle of deflation.[51] It is not necessarily rejected by Austrians.[52] Where the Keynesians and the Austrians differ, at least on this point, is on the solution. While Keynesians, such as Krugman, argue for inflationary monetary policy,[53] Austrians instead see the resulting fall in the price level as the cure for deflation (or fall in the money supply).[54]

Recognizing the problem as the result of a fall in profit, due to the deceleration of credit expansion, the problem of demand necessarily stems from the inability to pay for products demanded. The solution is a fall in prices of relevant goods and services, to the point where demand for them can once again rise.[55] In other words, conceding that a fall in the money supply will lead to a decline in spending, the only method by which spending can rise is through a fall in the price level.

"The depression period is one in which the structure of production readjusts according to society's time preference, and so the most sensible approach to returning to economic stability is allowing this readjustment to take place the fastest possible."

The alternative method, or the Keynesian "solution" of inflation, can lead to a temporary "recovery."[56] Nonetheless, such a policy would inevitably result in greater malinvestment and a greater net loss of wealth.[57]

While the Keynesian case for inflation has been dealt with, there still lies the supposed problem of the liquidity trap. Krugman's liquidity trap becomes theoretically unsustainable once we dispel the myth of the supposed deflationary spiral.

However, rising uncertainty and low expectations for the future, brought about by economic depression, can be considered legitimate factors behind a liquidity trap. In this case, we define a liquidity trap as a situation in which private investment stagnates despite the readjustment of the structure of production. One such situation of this occurring was during the Great Depression. This topic is tackled by Robert Higgs, in which he attaches the blame to "regime uncertainty," or uncertainty caused by a general antibusiness climate produced by the government.[58]

While we cannot accuse the current government of causing the same disruption as did the Roosevelt administration during the Great Depression, it nevertheless stands that the onset of the current recession and the sheer amount of bankruptcies that resulted were enough to shatter confidence. While the bailouts perhaps managed to salvage the balance sheets of those banks fortunate enough to receive government money, it failed to aid these banks to stabilize. Since there are low expectations for stability, it only makes sense that private investment remains stagnant. Furthermore, it is very possible that the threat of higher taxes due to increased government debt and deficits has also factored into business expectations.

The final remaining question is whether or not a natural readaptation of the structure of production to society's time preference can be aided through government spending. This is, of course, the other side of the Keynesian coin — if not monetary policy, then fiscal policy must be the solution.[59]

An Austrian would argue a resounding "no." Wealth-producing investment relies on two underlying factors: that there exists a demand for the product and that the producer can satisfy that demand at a profit or by receiving greater satisfaction in return. That government cannot satisfy another's demand at a profit can be extrapolated empirically, because if it could, there would be no need for deficit spending — the capital necessary to fund these programs would come from received profits. As such, government spending usually results in a net loss in wealth, as less wealth is produced than the amount invested in the first place. Ergo, government spending absolutely cannot replace private investment.

The typical "redistribution of wealth" argument doesn't directly pertain to the Keynesian case for deficit spending, because the Keynesians adamantly believe that government spending will cause an increase in net and sustainable output, and as a result the burden of these deficits in terms of percentage of income taxed will be much smaller in the future than they are in the present (thus, the point of running deficits). But, the argument for deficit spending falls to pieces if government spending does not result in higher economic growth.

Fulfillment of satisfaction is dependent on individual subjective evaluations and voluntary exchange. Government, instead, distributes capital towards otherwise unwanted ends, taking it away from the private sector and "producing" at a net loss. The ultimate consequence is the destruction of wealth.[60] While in a vibrant economy wealth creation by the private sector may outstrip wealth destruction by the public sector, in eras of depressed private investment government spending could be potentially disastrous.

Hayek and Unemployment

Paul Krugman frequently suggests that "facts have a well-known liberal bias."[61] The present essay argues otherwise. The evidence overwhelmingly suggests that the best possible route to economic recovery is through the free-market and by allowing the structure of production to readapt itself. The Austrian case shows why monetary policy and fiscal policy are not effective methods by which to accelerate the pace at which this readaptation occurs.

Krugman accuses Hayek of seeing unemployment as a good thing, but nothing could be further from the truth. Hayek clearly considers unemployment a result of interference with the price mechanism, caused by credit expansion. Hayek, like anybody else, would rather see as many individuals employed as possible, as he was a defender of capitalism and as such valued economic growth through voluntary exchange. The difference between Hayek and Krugman is that Hayek was not a utopian, and realized that economic growth can only once again take place if the structure of production adapts to society's time preference — there is no formula by which government can centrally plan wealth creation.

While Krugman's policy could perhaps lead to a temporary surge in employment, we have shown that over the long run such policies are unsustainable. The only long-run results are the destruction of wealth and even greater unemployment. If Hayek supported "persistent unemployment," then there are few good words one could offer to describe Krugman's position.


[1] While Paul Krugman is a Keynesian, not all Keynesians agree with Paul Krugman. As such, any Keynesian reader who takes offense at the criticism aimed at Krugman and equivocated with general Keynesian theory should recognize that this characterization is meant for the sake of simplicity.

[2] Paul Krugman (December 1998), "The Hangover Theory." In response to Krugman's early criticism, the following replies were written: Garrison (1998), "Contra Krugman"; Shostak (1998), "In Defense of Austrian Theory"; Epstein (1998), " Epstein Responds"; Cochran (2001), "The Hangover Theory?"; Gordon (2009), "Hangover Theory: How Paul Krugman Has Misconceived Austrian Theory." For more recent criticism, see the following Krugman blog posts: "Martin and the Austrians" and "Austrian Followup."

[3] Bradford DeLong (2000). Slouching Towards Utopia: The Economic History of the Twentieth Century.

[4] The full passage reads: "And, if we pass from the moment of actual crisis to the situation in the following depression, it is still more difficult to see what lasting good effects can come from credit-expansion. The thing which is needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production to the proportion between the demand for consumers' goods and the demand for producers' goods as determined by voluntary saving and spending. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to 'mobilise' all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes." From Prices & Production and Other Works.

[5] Krugman (May 3, 2010), "The Augustine Economy." Krugman writes, "we're still in a liquidity trap, with Fed policy constrained by the zero lower bound. And a liquidity trap world is a paradox-of-thrift world, in which the virtuous individual decision to save more is a vice from the point of view of the economy as a whole. For now, it's actually a good thing that consumers are behaving irresponsibly."

[6] Krugman (March 17, 2010), "How Much of the World Is In a Liquidity Trap?" According to Krugman, "As I've written many times in various contexts since the crisis began, being in a liquidity trap reverses many of the usual rules of economic policy. Virtue becomes vice: attempts to save more actually make us poorer, in both the short and the long run. Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster. Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners' expense. For the moment — or more likely for the next several years — we're living in a world in which none of what you learned in Econ 101 applies."

[7] Mauro Boianovsky (2004), "The IS-LM Model and the Liquidity Trap Concept: From Hicks to Krugman." History of Political Economy, 36; p. 92.

[8] Ibid., p. 116. "Krugman's discussion of the liquidity trap concept is particularly relevant for the purposes of the present essay, since he presents it as a part of an intended reformulation of Hick's original IS-LM model…"

[9] John Maynard Keynes (2008). The General Theory of Employment, Interest, and Money. BN Publishing, p. 207.

[10] Ibid., p. 205. "We can sum up the above in the proposition that in any given state of expectation, there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transaction-motive or the precautionary-motive, which will realise itself in actual cash-holdings in a degree which depends on the terms on which the monetary authority is willing to create cash."

[11] Gerald P. O'Driscoll (July 2010), "Keynes vs. Hayek: The Great Debate Continues," Wall Street Journal. Writes O'Driscoll, "If a person decides to save, there is no assurance that the funds 'will find their way into investment in new capital construction by public or private concerns.' They cite a 'lack of confidence' as the reason that savings is not intermediated into investment."

[12] Nicholas W. Schrock and W. James Smith (1979), "Keynes, the Keynesians, and Friedman: Three Views of Money in the Trap," Journal of Post Keynesian Economics 2(1), p. 136. "For Keynes, in contrast to Friedman, the liquidity trap is a condition not of equilibrium but of disequilibrium, because asset holders prefer money to bonds. Money does matter. Asset holders will substitute money for bonds and will hold additional assets in the form of money but will neither substitute bonds for money nor willingly hold additional assets in the form of bonds without an increase in compensation. Because Keynes' speculators prefer money to bonds, they are not risk neutral. For them, and for the system, money possesses distinctive importance."

[13] Ibid., pp. 136–37. "Open market operations can increase the money supply at the trap rate without affecting income."

[14] Keynes (2008), p, 208. "As the pure rate of interest declines it does not follow that the allowances for expense and risk decline pari passu. Thus the rate of interest which the typical borrower has to pay may decline more slowly than the pure rate of interest, and may be incapable of being brought, by the methods of the existing banking and financial organisation, below a certain minimum figure."

[15] Ibid., p. 207. "Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest."

[16] John R. Hicks (1937), "Mr. Keynes and the Classics: A Suggested Interpretation," Econometrica 2, pp. 147–59.

[17] Distinguishing between price and monetary deflation/inflation is absolutely pivotal to understanding the Austrian criticism of the Keynesian liquidity trap. Austrians do not recognize price deflation, or a fall in the price level, as a threat. Instead, the threat is formed by monetary deflation, or a fall in the supply of money. See George Reisman (August 2003), "The Anatomy of Deflation." While the Keynesian fear of price deflation is an important mistake that will have to be addressed below, it is not especially pertinent to liquidity-trap theory.

[18] Boianovsky (2004), p. 95.

[19] Ibid., pp. 96–99.

[20] Hicks (1937), pp. 154–55.

[21] N. Kaldor (1937), "Prof. Pigou on Money Wages in Relation to Unemployment," Economic Journal 47, pp. 745–53.

[22] F. Modigliani (1944), "Liquidity Preference and the Theory of Interest and Money," Econometrica 12, pp. 45–88.

[23] Lawrence R. Klein (1947), The Keynesian Revolution (New York: Macmillan) and Boianovsky (2004), p. 107. "Hicks's IS-LM analysis attracted the attention of the profession until it became the standard representation of 'Keynesian economics.'"

[24] Boianovsky (2004), p. 112.

[25] Ibid., pp. 112–113. "The Keynesian liquidity trap argument gradually receded into the background in the macroeconomic literature of the 1970s and 1980s. The increasing attention devoted to the microfoundations of price and wage rigidity was one reason behind the relative marginalization of IS-LM analysis. Hicks himself was part of that shift with his contributions to the fixprice literature (see his 1979 account of how he moved beyond 'IS-LM Keynesianism' after the late 1950s)."

[26] Krugman (1998), "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity 1998(2), p. 137. Writes Krugman, "the liquidity trap has steadily receded both as a memory and as a subject of economic research. In part, this is because in the generally inflationary decades after World War II nominal interest rates have stayed comfortably above zero, and therefore central banks have no longer found themselves 'pushing on a string.'"

[27] Milton Friedman and Anna J. Schwartz (1963), A Monetary History of the United States, 1867–1960 (Princeton, New Jersey: Princeton University Press). Krugman comments, "Emphasizing broad aggregates rather than interest rates or the monetary base, Friedman and Schwartz argue, in effect, that the Depression was caused by monetary contraction; that the Federal Reserve could have prevented it; and implicitly, that even the great slump could have been reversed by sufficiently aggressive monetary expansion. To the extent that modern macroeconomists think about liquidity traps at all (the on-line database EconLit lists only twenty-one papers with that phrase in title, subject, or abstract since 1975), their view is basically that a liquidity trap cannot happen, did not happen, and will not happen again" (Krugman [2008], p. 138). Interestingly, it is possible that not even Keynes considered the Great Depression an example of his idea of "absolute" liquidity preference. Keynes wrote, "But whilst this limiting case might become practically important in the future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test" (Keynes [2008], p. 207). Both the monetarist view (Friedman and Schwartz) and the Keynesian view are rejected by Murray Rothbard, who put forth an Austrian explanation for the Great Depression in his seminal work America's Great Depression.

[28] Boianovsky (2004), p. 113. "The lack of empirical support for a liquidity trap (in the Hansen-Tobin sense) in econometric studies of the demand for money carried out in the 1960s also contributed to the criticism of that concept."

[29] Krugman (1998), p. 141.

[30] Ibid., p. 142. "In short, approaching the question from this high level of abstraction suggests that a liquidity trap involves a kind of credibility problem. A monetary expansion that the market expects to be sustained (that is, matched by equiproportional expansions in all future periods) will always work, whatever structural problems the economy might have; if monetary expansion does not work — if there is a liquidity trap — it must be because the public does not expect it to be sustained."

[31] Boianovsky (2004), p. 118. "In this context, a liquidity trap arises if the economy is beset by deflationary expectations that shift the CC curve to the left or if the natural interest rate is negative because of the time preferences of individuals."

[32] Scott Sumner (2002), "Some Observations on the Return of the Liquidity Trap," Cato Journal 21(3), pp. 483–84.

[33] Theodore Pelagidis and Evangelia Desli (2004), "Deficits, Growth, and the Current Slowdown: What Role for Fiscal Policy?" Journal of Post Keynesian Economics 26(3), p. 463. "Indeed, in periods of very low interest rates, to strengthen economic activity and increase employment, the implementation of discretionary fiscal policy should be a government's priority in order to stimulate total demand and increase output and investments, rather than further interest rate reductions alone."

[34] Krugman (1998), pp. 158–59. "But in reality, fiscal policy would surely have some impact… If current income has very strong impacts on spending, so that the marginal propensity to spend (consumption plus investment) is actually greater than one over some range, there can be multiple equilibria. A liquidity trap may therefore represent a low-level equilibrium, and a sufficiently large temporary fiscal expansion could jolt the economy out of that equilibrium into a region where conventional monetary policy worked again."

[35] Ibid., p. 159. See Robert Higgs (2006), Depression, War, and Cold War (Oakland, California: The Independent Institute). Specifically, refer to "Wartime Prosperity?", where Higgs rejects the idea that the Second World War could have provided the impetus necessary to bring the economy out of the Great Depression.

[36] Bradford DeLong, "Deficit-Neutral Stimulus."

[37] Krugman (2008), pp. 160–61. "However, as I noted at the beginning, only temporary monetary expansions are ineffectual. If a monetary expansion is perceived to be permanent, it will raise prices (in a full-employment model) or output (if current prices are predetermined)." In "How Much Can the Fed Help? (Wonkish)," Krugman writes, "Way back when, Goldman Sachs guesstimated that it would take an expansion of the Fed's balance sheet to $10 trillion to accomplish as much as the reduction in short rates the Fed would have undertaken already if it weren't up against the zero lower bound. That still sounds plausible."

[38] Lars E. Svensson (2003), "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," The Journal of Economic Perspectives 17(4), p. 150. "[T]he best possible rational expectations equilibrium is one where the central bank intentionally conducts more expansionary policy and causes a higher inflation in the future so as to shorten the current recession and deflation."

[39] For an introduction to Austrian economics, including a brief history of the school, see Jonathan M. Finegold Catalán (June 2010), "A Primer on Austrian Economics."

[40] As John Cochran writes in "Capital in Disequilibrium: An Austrian Approach to Recession and RecoveryDownload PDF," "To understand what is happening during a recession and recovery requires a 'view of capital that is firmly rooted in individual planning in a disequilibrium world'."

[41] Hayek (2008), p. 242. "Only because a number of individuals had decided to spend a smaller share of their total money receipts on consumption and a larger share on production was there any change in the structure of production."

[42] Jesús Huerta de Soto (2009), Money, Bank Credit, and Economic Cycles (Auburn, Alabama: Ludwig von Mises Institute), pp. 325–33.

[43] Austrians generally agree that equilibrium is not attainable, given that supply and demand are consistently shifting and there is imperfect information. Nevertheless, the value of equilibrium models are just that — they serve to model the theoretical.

[44] Investment into capital goods increases when the rate of interest decreases, because the value of capital goods is dependent on the rate of return. In other words, a decrease in the rate of interest makes capital goods cheaper, since the entrepreneur has to pay a smaller margin of his profit towards the interest on borrowing the funds necessary to procure these capital goods. Huerta de Soto explains, "The relative reduction credit expansion causes in the interest rate boosts the present value of capital goods, since the flow of rents they are expected to produce increases in value when discounted using a lower market rate of interest." Huerta de Soto (2009), p. 349.

[45] Ibid., p. 350. "Nevertheless we must emphasize that although the initial effects may be very similar to those which, as we saw, follow an upsurge in voluntary saving, in this case the productive stages are lengthened and widened only as a consequence of the easier credit terms bank offer at relatively lower interest rates yet without any previous growth in voluntary saving."

[46] Ludwig von Mises (1998), Human Action (Auburn, Alabama: Ludwig von Mises Institute), p. 788. "These economists too must admit and do admit that the upswing is invariably conditioned by credit expansion, and that it turns into depression when the further progress of credit expansion stops."

[47] Rothbard, America's Great Depression, p. 34. Rothbard quotes Mises, "The essence of the credit-expansion boom is not overinvestment, but investment in the wrong lines, i.e., malinvestment on a scale for which capital goods available do not suffice."

[48] Ibid., pp. 21–25.

[49] Although it is not necessarily pertinent to this essay, it is noteworthy that there is no consensus even amongst Austrian economists on how the free market would respond to an increase in the demand for money. Ludwig von Mises's analysis is open to interpretation — and interpretations vary as much as interpreters — and Friedrich Hayek tended to flip-flop, to a very marginal degree, on the topic. Two main branches of Austrian banking theory were developed. The supporters of the first, under the guidance of Rothbard, are known as the "100-percent reservists." A seminal work on this particular banking theory is Murray Rothbard's Mystery of Banking. Jesús Huerta de Soto's Money, Bank Credit, and Economic Cycles also covers 100-percent reserve-banking theory very well. The other school is Larry White and George Selgin's "free-banking school." Selgin's The Theory of Free Banking is the best book on the subject. The important point of contention is that the free-banking school believes in the concept of "monetary equilibrium" and that monetary stability is best achieved by meeting an increase in demand for "inside money" (bank notes) with an increase in the supply of inside money. Regarding changes in the supply of base money, for example gold, see Jörg Guido Hülsmann (October 2009), "The Demand for Money and the Time-Structure of Production."

[50] Irving Fisher (1933), "The Debt-Deflation Theory of Great DepressionsDownload PDF."

[51] Krugman (February 2009), "On the Edge," New York Times. "As the great American economist Irving Fisher pointed out almost 80 years ago, deflation, once started, tends to feed on itself. As dollar incomes fall in the face of a depressed economy, the burden of debt becomes harder to bear, while the expectation of further price declines discourages investment spending. These effects of deflation depress the economy further, which leads to more deflation, and so on."

[52] George Reisman (1990), Capitalism: A Complete and Integrated Understanding of the Nature and Value of Human Economic Life (Laguna Hills, California: TSJ Books), p. 939. Reisman argues, "The failure of banks, of course, causes the money supply actually to be reduced, since banks' outstanding checking deposits are part of the money supply. The reduction in the money supply then leads to a further decline in spending, revenue and income, and thus to still more bankruptcies and bank failures. The process feeds on itself, potentially to the point of eliminating all fiduciary media from the money supply and making the money supply equivalent to the supply of standard money alone."

[53] Krugman, "Can Deflation Be Prevented?" "The point is that deflation should — or so we thought — be easy to prevent: just print more money." In the advent of a liquidity trap, Krugman, as aforementioned, argues for even greater monetary pumping and substantial fiscal stimulus.

[54] George Reisman (January 2009), "Falling Prices Are the Antidote to Deflation."

[55] Ibid.

[56] Huerta de Soto (2008), p. 401. "The need for this ever-escalating increase in the rate of credit expansion rests on the fact that in each time period the rate must exceed the rise in the price of consumer goods, a rise which results from the greater monetary demand for these goods following the jump in the nominal income of the original factors of production."

[57] Mises (1998), pp. 428–29. "Inflationary or expansionist policy must result in overconsumption on the one hand and in malinvestment on the other. It thus squanders capital and impairs the future state of want-satisfaction."

[58] Higgs (2006), pp. 1–36. "My hypothesis is a variant of an old idea: The willingness of business people to invest requires a sufficiently healthy state of 'business confidence,' and the Second New Deal ravaged the requisite confidence."

[59] For two relatively clear overviews of the role of fiscal policy during periods of depression/recession, see Pelagidis and Desli (2004) and, Philip Arestis and Malcolm Sawyer (2003), "Reinventing Fiscal Policy," Journal of Post Keynesian Economics, pp. 3–25.

[60] Reisman (1990), p. 552.

[61] Krugman, "Invincible Ignorance." "Also, for those readers who complain that I'm too partisan, that I should admit that there are two sides to the issues, this is a prime example of my problem. How am I supposed to pretend that these are serious people? The facts really do have a well-known liberal bias."