An open letter to Paul Krugman, from monetary economist Scott Sumner.
And Krugman's (non)response. It's embarrassing to see a Nobelist respond to serious arguments with snide put-downs. But here's the closest thing to a counter-argument offered by Krugman:
My view, which I thought was pretty clear, is that the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another. If the Fed could credibly commit to inflation at rates higher than the 2-ish percent target it’s already believed to have, that would be effective. But right now I don’t see that as a realistic option, hence the emphasis on fiscal policy and bank recapitalization.
Presumably, Krugman thinks we are in a liquidity trap because the Fed can't credibly commit to boost future inflation. In other words, expectations of (low) future inflation prevent monetary policy from taking hold in the present circumstances, thus reducing the monetary "multiplier" (i.e. velocity of money). In Krugman's mind, this is so self-evident that he doesn't even need to consider things like quantitative easing or eliminating interest payments for excess bank reserves. Banks (and investors) have expectations of future inflation, which makes monetary policy ineffective in a liquidity trap, full stop.
Why, then, are Krugman and his minions so dismissive of the "Treasury View" that the fiscal multiplier is greatly diminished by crowding out private spending because of expectations of future tax increases? Why are one set of expectations enough to make monetary policy completely ineffective, but not have any effect on fiscal policy? For this view to be coherent, there must be some fundamental difference between expectations over future inflation and future taxes, but I can't see what it is. Both expectations come from beliefs about future real net income.
Especially since, as Krugman himself noted earlier today, both banks and consumers are hoarding cash right now. I would expect Krugman to say that we need to government to spend precisely because banks and consumers are hoarding cash. But that only moves the money once: after the government spend the cash, whoever receives it will just hoard it and there is no stimulative effect. In order to get the money moving on a more sustained basis, there has be a story about how consumer expectations improve when faced with fiscal stimulus but remain unchanged when faced with monetary stimulus.
So what's the story?