The View From 1776

Hayek vs. Krugman Re Keynes’s “Liquidity Trap”

Krugman is still riding a dead horse from Franklin Roosevelt’s disastrous New Deal.

A liquidity trap, in the various versions of Keynesian theory, occurs in a recession when businesses and consumers prefer to hold cash rather than to commit their funds to increased consumption or investment.  The present manifestation of this condition is the low velocity of money in circulation.  The Fed has pumped trillions of dollars into the financial markets, but bank loan demand remains low and businesses are holding huge amounts of cash, while consumers are saving more and paying down their debts.

Paul Krugman’s neo-Keynesian thesis is that this situation will grow worse, leading us into another depression, unless the Federal government steps into the picture and spends ever more fiat money for an indefinitely long time period.  His thesis is little more than the failed “pump priming” policy of Franklin Roosevelt’s New Deal, a policy that contributed to converting an ordinary recession into twelve years of economic misery.

The Austrian economic thesis is that government intervention has frightened businessmen and consumers, causing them to take a wait-and-see posture.  Obama has made clear that he intends to socialize as much of the economy as possible, especially energy production and use, along with our financial institutions.

Businessmen have repeatedly been alarmed by such thrusts as Obama’s stimulus plan, his take-over of the automobile industry, seizing control of the financial markets, continual business-bashing, Obamacare, threats to stifle business free speech while giving free rein to labor unions, and huge tax increases.

In addition to leading to paralysis of new investment and creation of new jobs, Obama’s damn-the-torpedoes rush to socialize as much of the economy as possible has prevented an orderly liquidation of excess inventories and uneconomic businesses, both of which are essential if private businessmen and individual consumers are to bring us back to economic growth and higher employment.

For a deeper understanding of Paul Krugman’s Keynesian lust for ever larger and longer lasting Federal deficit spending, read Jonathan M. Finegold Catalan’s essay on the website.


Krugman would temporarily alleviate the fall in employment and production through public expenditure; however, the problem with loose fiscal policy is that government cannot distribute and invest capital efficiently or profitably. Furthermore, government countercyclical policy tends to create regime uncertainty, which may directly contribute to the existence of this “liquidity trap.”

...While Keynes and Hicks would have perhaps shied away from massive monetary stimulus, operating with the understanding that monetary policy was ineffective during a liquidity trap, New Keynesian theory puts much more importance on a growing money supply. In fact, Krugman’s monetary solution to a liquidity trap is sustained inflation, where the central bank reverses fears of future deflation by instead causing an increase in the price level through massive monetary pumping (Krugman estimates this to be in the area of $10 trillion, borrowing the figure from a prior study conducted by Goldman Sachs). Periods of relatively high inflation would not be temporary, as to assuage fears of future deflation. Instead, the “optimum” monetary policy is one that targets relatively high inflation for a period long enough to shift the public’s rational expectations.

As is, the Keynesian “solutions” to a liquidity-trap run in the face of Austrian capital and calculation theory. The idea that government investment is as good as private investment is highly suspect, while a policy of monetary inflation is bound to lead to malinvestment.