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.I did not make up these things. Krugman is claiming that the very things that Mandeville declared almost 300 years ago all are true.
So, are you cutting back purchases, getting out of debt, and building up your savings? Then you are an Enemy of the People, for you are engaged not only in folly, but folly that is destroying our economy and making us poorer.
Krugman defines the "liquidity trap" (which came from John Maynard Keynes) as such:
In my analysis, you’re in a liquidity trap when conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero.It is difficult to point out all of the major fallacies here, as time and space stand in the way, but let me say that anyone who has read Murray Rothbard's America's Great Depression or Henry Hazlitt's classic Economics in One Lesson can see just how badly Krugman misses the mark. In Krugman's world, an economy is not made up of purposeful individuals who engage in mutually-beneficial exchange in order to better themselves.
Now, you may object that there are other things central banks can do, and that they actually do these things to some extent: they can purchase longer-term government securities or other assets, they can try to raise their inflation targets in a credible way. And I very much want the Fed to do more of these things.
But the reality is that unconventional monetary policy is difficult, perceived as risky, and never pursued with the vigor of conventional monetary policy.
No, according to Krugman, an economy is a perpetual motion machine, an entity that needs (in Krugman's words) "traction." Just push the thing forward via government spending and -- yes -- inflation, and it will run by itself. However, in the meantime, make sure everyone spends whatever they have, and go into huge debt, if necessary, or the motion machine will stop working.
Krugman claims that the economy is greased by spending, but spending, especially in the Keynesian view, is a much different concept than consumption. Under a spending regime in Keynesian economics, people simply are "buying back the products" that they have produced. In other words, they are clearing the shelves so they can produce more stuff to put on the shelves.
This is not purposeful activity; it is a caricature of an economy and certainly is a caricature of what consumers actually do. People don't spend so they can produce more goods so that they can spend and keep the process going indefinitely.
In this view, there is no particular structure of production. As a professor at the recent Austrian Scholars Conference told me, Keynesianism would hold that it does not matter if the capital improvements at his college involve building new buildings and improving old ones, or if all of the money were spent building a new bell tower that would rival the old Tower of Babel, since the only thing that matters is spending.
The problem is not that consumers are failing to spend enough money. Instead, as the Austrians have pointed out time and again, the problem is that during the past decade, government policies have directed people to create huge amounts of malinvestments that must be liquidated before we can have a recovery. Instead, Krugman and the world's politicians and central bankers are insisting that we just keep going in the same unsustainable direction and somehow the light at the end of the tunnel will be a ray of sunshine instead of the train headed straight at us.