In his column today, Paul Krugman notes that trying to budget-balance in the middle of a “liquidity trap” is a bad idea. He gives two examples (emphasis mine):
The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment. The second episode took place 60 years later, in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.
So, in both cases, government cut spending and prolonged a recession. But that’s not all! In both cases, government also raised taxes and prolonged a recession. Funny, Krugman doesn’t focus much – doesn’t focus at all, in fact – on this part of his evidence. A “liquidity trap,” according to Krugman, is a situation in which “the monetary authority had cut interest rates as far as it could, yet the economy was still operating far below capacity.” A situation a lot like today, in other words. The chances that the Bush tax cuts remain in place after 2010 just got a little bit higher.
