Liquidity trap?

From the pages of The New York Times Keynesian economist Paul Krugman has been recycling for months the "demand-creates-its-own-supply" fairy-tale. At the core of this ideology stands the belief that consumption, not production, is the engine of growth. Keynesians fear that the irrationally pessimistic consumer is unwilling to spend his savings. Thus the government needs to borrow a few trillion from the hoarded funds and spend them to restore confidence and revitalize the market.

It is one thing for journalists to be obsessed with how much households spend between Thanksgiving and Christmas. It is another for a Nobel-winning economist to ignore the fact that our economy is not driven exclusively by the current demand for final goods. The oversimplified idea that a slump in consumption inevitably brings a vicious cycle of depressed investment activities, lowering of the national income, and further fall in consumption do not stand the test of rigorous empirical studies. Not even those conducted by Keynesian Nobel laureates for economics such as Franco Modigliani and Robert Solow!

Unlike Krugman's horror story of the liquidity trap (popularized by another Nobel-winning Paul, Samuelson), real-life recessions do not turn into depressions on their own. The natural fall in interest rates aided by expansionary monetary policy and the fall in nominal prices temporarily increases the real value of all savings, whether in cash, government securities, or other highly liquid assets. Such changes may be very painful for those who have lived beyond their means, as it increases their real indebtedness. But it also rewards the prudent and creates incentives for future generations to be thrifty.

A laissez-faire approach to a recession contains the seeds of recovery in the form of higher aggregate demand (the use of Keynesian terminology is intentional). Families that have been saving instead of taking loans they cannot repay during the preceding economic expansion are now in a position to buy a new entertainment center, find a great package for an all-inclusive vacation at the beach, replace their old Honda Accord with a new Chevy Uplander, and perhaps even acquire the house of their dreams.