The Misuse of Economic History: Flawed Analogies with Japan's "Liquidity Trap" and the Great Depression

By Reynolds, Alan | The Cato Journal, Fall 2009 | Go to article overview
Save to active project

The Misuse of Economic History: Flawed Analogies with Japan's "Liquidity Trap" and the Great Depression


Reynolds, Alan, The Cato Journal


Paul Samuelson (2005: 242) advises that, "The sage economist must muster best available knowledge about history and theory in giving plausible pragmatic advice." Economists frequently use historical anecdotes to justify theories they prefer and policies they advocate. Unfortunately, policy-motivated history often depends on "stylized" facts and hazy metaphors--such as bubbles bursting, central banks pushing on strings, and budget deficits jump-starting the economy.

By early 2009, the global recession and financial crisis were being widely compared to the Great Depression or Japan's "Lost Decade." Writing about the U.S. economy in mid-2009, Krugman (2009a) notes this is "the third time in history that a major economy has found itself in a liquidity trap." The other two traps were the United States in 1929-39 and Japan in the 1990s. In all three cases, he argues, the alleged impotence of monetary policy justifies very large debt-financed government spending plans. On the basis of theory, Krugman (1998) once proclaimed, "When the economy is in a liquidity trap, government spending should expand up to the point at which full employment is restored" (emphasis in the original).

The Federal Reserve more than doubled the monetary base in five months, between August 2008 and January 2009. In response, Krugman (2009a) wrote that, "A rising monetary base isn't inflationary when you're in a liquidity trap. America's monetary base doubled between 1929 and 1939; prices fell 19 percent. Japan's monetary base rose 85 percent between 1997 and 2003; deflation continued apace."

There is no question that the demand for base money increases substantially during any period of widespread bank runs and failures. Banks naturally want more reserves as a cushion against possible bank runs, and the public wants to keep less cash in banks and more in currency. A liquidity trap, however, suggests the demand for reserves and currency is insatiable, so central banks cannot possibly finance inflation or even resist deflation (Boianovsky 2004). As Krugman (2009b) explains, "My definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy--open-market purchases of short-term government debt--has lost effectiveness. Period. End of story." Taken literally, that definition implies the Federal Reserve could buy up outstanding Treasury bills and commercial paper without the slightest risk of inflation (Hamilton 2008, Grier 2008).

This article questions the data Krugman uses to suggest that the Federal Reserve's recent doubling of the monetary base in five months was in any sense comparable to (1) what the Fed did in 1929-39 and (2) what the Bank of Japan did during the Lost Decade. I find that monetary policy was not ineffective (for good or ill) in the United States during the 1930s, or in Japan since 1991.

Krugman uses the alleged impotence of monetary policy as an argument for aggressive use of debt-financed government purchases and transfers. But his argument is problematic. Ineffectiveness of monetary stimulus would not demonstrate the effectiveness of fiscal stimulus. Indeed, I find no evidence that traditional fiscal policy stimulated real or nominal GDP growth during the Great Depression or Japan's Lost Decade. These historical case studies are consistent with other evidence casting doubt on the empirical validity of the view that budget deficits are an effective way to accelerate growth of domestic demand.

Liquidity Trap in the Great Depression?

Keynes (1937: 207-8) described something similar to a hypothetical liquidity trap. But he said, "I know of no example of it" other than a "very abnormal" episode "in the United States at certain dates in 1932."

By writing that "America's monetary base doubled between 1929 and 1939; prices fell 19 percent," by contrast, Krugman implies that monetary policy was ineffective against an entire decade of continuous deflation.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
Loading One moment ...
Project items
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited article

The Misuse of Economic History: Flawed Analogies with Japan's "Liquidity Trap" and the Great Depression
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

While we understand printed pages are helpful to our users, this limitation is necessary to help protect our publishers' copyrighted material and prevent its unlawful distribution. We are sorry for any inconvenience.
Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.

Are you sure you want to delete this highlight?