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.In other words, interest rates are at about zero (or what he calls the "zero-bound,"), which means that typical monetary policy in which the Federal Reserve System increases bank reserves which then can be lent to businesses for capital expansion is ineffective. When that happens, Keynesians then recommend the government follow "fiscal policy," in which the government borrows (or prints money) and spends it directly in the economy as a "stimulus."
Krugman is quite consistent on this point. He goes by the following syllogism:
- Spending drives the economy, and there must be a certain level of spending to keep the economy afloat;
- Private investors are not borrowing enough even though there are lots of bank reserves, which means the economy is in a "liquidity trap";
- Therefore, to boost spending, government must directly spend by borrowing or getting the Federal Reserve System to purchase government bonds directly, which will "stimulate" the economy and allow us to "spend our way out of the" depression.
In a recent post on his NYT blog, Krugman again claims that the rules are different because much of the world is in a "liquidity trap."
However, there is a different approach, as is laid out by Murray N. Rothbard in his classic America's Great Depression. I include Rothbard's description and criticism of the "liquidity trap" in this link. It is quite long, so I don't include the text in this post. However, it is worth reading if you wish to understand that theoretical basis for the current government policies, and a good antidote to them.