Some economists claim the economy is in a Keynesian liquidity trap, which makes it a special case calling for “unorthodox” policies. Paul Krugman writes:
I know that some people find this hard to understand — perhaps because they don’t want to understand — but people like me have never claimed that fiscal expansion is always and everywhere the right policy, even in response to recession…. All of the unorthodox policy recommendations and conclusions are contingent on the economy being in a liquidity trap, in which short-run nominal interest rates are up against the zero lower bound and can’t go lower.
And liquidity-trap conditions are rare; in fact, they’ve only happened twice in US history. Unfortunately, we’re living in one of those episodes right now.
Well, are we in a liquidity trap? And does the present situation require constant bursts of government spending?
Of course, Keynesians believe the answer to the first question is a resounding yes. The answer to the second logically would follow from the first: If Keynesianism really is true, only monetary policy and fiscal policy are available, and economic conditions determine their use.
The Government Alternative
Under the Keynesian paradigm, if monetary authorities cannot stimulate private spending by forcing down interest rates, then the only other avenue is for the government to borrow and create new money, and spend on its own projects. If the first option does not work, the second, by definition, must.
But in America’s Great Depression, Murray N. Rothbard said there is no liquidity trap:
Keynesians claim that “liquidity preference” (demand for money) may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression. This statement assumes that the rate of interest is determined by “liquidity preference” instead of by time preference; and it also assumes again that the link between savings and investment is very tenuous indeed, only tentatively exerting itself through the rate of interest. But, on the contrary, it is not a question of saving and investment each being acted upon by the rate of interest; in fact, saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with this matter.
Rothbard continued that the very things Keynesians claim will worsen an economic downturn – including falling wages and prices and liquidation of capital – actually are necessary to speed up the readjustment. The Austrian-Keynesian divide is fundamental on this point; Austrians not only reject the liquidity-trap paradigm, but also hold that the problem is boom-induced malinvested capital rather than idle capital.
Idle or Malinvested?
The distinction is important because Austrians say the economy cannot recover until the malinvested capital is transferred to other uses, liquidated, or abandoned altogether. Keynesians, on the other hand, claim that if government can spend enough money, the same capital that Austrians say is malinvested will be returned to full employment.
In other words, Keynesians hold that capital (as well as other factors of production) is homogeneous. An economy is like a cake mixture: Stir in water (money) and an economy appears. The only important ingredient is spending, and lots of it.
Austrians in contrast believe that an economy consists of heterogeneous assets that are directed by consumer choices. Thus attempts by government to drive this process only result in resources being directed to unsustainable purposes. Furthermore, Austrians hold that the current situation is not in a special case; instead, the government is justifying its actions using bad theory. Governments can neither fool Mother Nature nor violate the laws of economics.