Is Krugman Right About the U.S. in a Liquidity Trap?


American economist Paul Krugman recently wrote in The New York Times about how soon there will be five years of an important date: US interest rates hitting the zero lower bound (ZLB), and entering in “a liquidity trap.”

“Five years! Yet many people, even many economists, are still in denial over what that means,” he says.

The following chart shows the ZLB in blue, and the FED’s QE in red, the latter showing an ever-increasing monetary base. However, the effectiveness on the nominal GDP is clearly decreasing –maybe because the effects of the monetary base on M2 (which is the green line in the chart below, and stands for a key economic indicator used to forecast inflation) are also of decreasing effectiveness.

Krugman and the ZLB

The latent theory here is that, if there is an X demand for liquidity relative to their wealth, it will be enough to increase the money so as to satisfy that X. Then, the expenditure will come. However, for five years we have seen that for every increase of nominal GDP’s M2, it is necessary an even greater advance of the monetary base.

M2 is the sum of paper currency and deposits used as a medium of exchange. The more the speed falls, the less effective the FED’s expansive policy is. In conclusion, the monetary impulses of the FED have been losing efectiveness since the ZLB was reached.

The above calls into question those who deny the existence of ZLB –also known as “the liquidity trap.” Monetarists, especially the MM, are the ones that deny such situation in which –according to Keynes, there is not an interest rate low enough so as to encourage investment. They think there is no limit, that issuing money is effective as long as it’s done in sufficient quantities. But the charts included in this post question such assertion.

Krugman 2.jog

As a matter of fact, the monetary base has multiplied by 3.6 and M2 by around 1.3 since the economic crisis began. What happened? On the one hand, the banking transmission channel did not work. M2 is the result of the monetary base and what the banking sector does with it. If the banking sector doesn’t provide access to credit, or if the access is much lower than before, then the monetary base “dies” on banking and doesn’t become a payment medium for people. So there is nor credit nor the parallel increase of deposits.

On the other hand, neither is there a credit demand. The potential investors behave in the same way than the banking sector: they amass cash but they don’t consume nor invest. People have negative expectations on the return of the investment, so they increase their holdings of assets.

So it is possible, as we have seen over the past few years, that however much the Central Banks increase their money emissions, it won’t change people’s preference for liquidity. It isn’t clear either that an increase in banking credit will swell investment, especially if investors own a higher than normal debt stock and if they don’t see a clear future profitability. The same applies to families.

*Image: Shutterstock

About the Author

Miguel Navascués
Miguel Navascués has worked as an economist at the Bank of Spain for 30 years, and focuses on international and monetary economics. He blogs in Spanish at: http://

2 Comments on "Is Krugman Right About the U.S. in a Liquidity Trap?"

  1. when the government electees lie, that causes people to hoard, when price inflation is not apparent.

  2. 8 dollars an hour verses .50 an hour doesn’t work. free trade doesn’t work. duhhh. but international banking pukes knew this all along.

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