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. …