We’re in a liquidity trap, with interest rates up against the zero bound. This means that conventional monetary policy isn’t sufficient. What should we do?
The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.
But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over....
So some readers have asked why I’m not making the same arguments for America now that I was making for Japan a decade ago. The answer is that I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time.
OK, so what’s next? The second-best answer would be a really big fiscal expansion, sufficient to mostly close the output gap. The economic case for doing that is really clear. But Washington is caught up in deficit phobia, and there doesn’t seem to be any chance of getting a big enough push.
That’s why, at this point, I’m turning to what I understand perfectly well to be a third-best solution: subsidizing jobs and promoting work-sharing.
So in a best-case scenario, the Fed could adopt a proper monetary stance, and the economy would be in a great shape. Unfortunately, the inflation-hawks there have eliminated this option, and Krugman is perfectly willing to accept their views as given (while spending the rest of his time trying to convince other people of different views). Scott Sumner, however, pushing this idea pretty hard.
One second-best approach Krugman highlights is job subsidies. As I've noted, these have been used by various Asian and European countries--even by ones that typically have rather flexible labor markets--to keep employment losses far below America's.
I think the virtues of these two approaches in combating tough economic conditions like those prevailing today is fairly clean-cut. The merits of a fiscal stimulus are more debatable, but for the moment let's count that as another tactic to fight economic Depressions.
The tragedy is that all three of these ideas are not on the table. We're down to the fourth and fifth-best economic policies.