First, D-squared pointed out that Krugman has written about the liquidity trap in Brookings Papers, and I wanted to link to the article. It is a long, interesting piece, and it deals with a number of issues that were new to me. Mostly, these have to do with the theoretical difficulty of building a model that generates the liquidity trap using "modern" macroeconomic concepts, such as expectations and international capital mobility.
One of the Brookings panelist's comments struck me.
Martin Baily noted that a risk-free interest rate near zero does not mean that the borrowing rate for investment in private capital is low. Just as in the Great Depression, there is now in Japan a substantial risk premium in private borrowing, and this may have increased as the environment has worsened. Consequently, it is wrong to infer from the risk-free rate that there is no constraint on borrowing or that the rate of return on capital investment is negative.
The fact that there are many interest rates in the economy, and that most of them are well above zero, makes it difficult for me to accept the liquidity trap as a description of reality. To me, the liquidity trap ultimately seems to rely on the textbook simplification of a single interest rate. That is why, for all of the elegance of Krugman's modeling, I come away thinking that the liquidity trap is still just a theoretical curiosity.
In another comment, GT wrote, "When you have people like Luskin on your side it kind of detracts from the seriousness of your arguments."
I reject guilt by association of this sort. I believe very strongly that economic arguments should be evaluated on the basis of their merits, not on the basis of who makes them. I am willing to quote anyone who makes an interesting economic argument. The gentleman to whom GT refers, Donald Luskin, writes for National Review Online. I have never quoted him.
Since early 1997, Japan’s broad money has increased by about 20%, its monetary base has surged by 84%, and the BOJ’s balance sheet has expanded by 122%. Yet over that same six-year period, Japanese nominal GDP has actually contracted by 6%.
That empirical data could be consistent with a liquidity trap. But the difference between an 84 percent increase in the monetary base and a 20 percent increase in broad money suggests that the troubled banks are soaking up a lot of the liquidity that the central bank tried to supply. Would the transmission mechanism from the monetary base to the money supply exhibit less slippage if the bad loans were written off rather than renewed?