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What is A Liquidity Trap And Why Should We Care?

June 15, 2009

Nobe Prize-winning economist and New York Times’ columnist Paul Krugman warns that the modest improvements to the economy caused by the stimulus package could be reversed, and our recession worsened, if conservative economists and Republican congressmen succeed in dismantling the economic policies that have begun the process of turning the economy around:

[f]or this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts, the conventional way to perk up the economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession.
Yet such unconventional measures make the conventionally minded uncomfortable, and they keep pushing for a return to normalcy. In previous liquidity-trap episodes, policy makers gave in to these pressures far too soon, plunging the economy back into crisis. And if the critics have their way, we’ll do the same thing this time.
The first example of policy in a liquidity trap comes from the 1930s. The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.
Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while F.D.R. tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

Mr. Krugman warns that economists like Arthur Laffer (who developed the Laffer Curve that Ronald Reagan found so convincing and George H.W. Bush called “voodoo economics” before he was offered the Vice-Presidential slot) and congressional Republicans are wrong to see inflation on our horizon when the economy has only begun the process of improvement.

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