While the other side was making these predictions, people like me were saying that classical economics was all wrong in a liquidity trap. Government borrowing did not confront a fixed supply of funds: we were in a paradox of thrift world, where desired savings (at full employment) exceeded desired investment, and hence savings would expand to meet the demand, and interest rates need not rise. As for inflation, increases in the monetary base would have no effect in a liquidity trap; deflation, not inflation, was the risk.
So, how has it turned out? The 10-year bond rate is about 2.5 percent, lower than it was when Ferguson made that prediction. Inflation keeps falling. The attacks on Keynesianism now come down to “but unemployment has stayed high!” which proves nothing — especially because if you took a Keynesian view seriously, it suggested even given what we knew in early 2009 that the stimulus was much too small to restore full employment.
The point is that recent events have actually amounted to a fairly clear test of Keynesian versus classical economics — and Keynesian economics won, hands down.
From How The Other Half Thinks – NYTimes.com
Krugman called it. Not only being among the first to identify the liquidity trap but the first to properly identify how the other side would respond, what errors they were making and what would be needed to restore the economy.
The development presents something of a chicken-and-egg situation: Corporations keep saving, waiting for the economy to perk up — but the economy is unlikely to perk up if corporations keep saving.
From Companies Borrow at Low Rates, but Don’t Spend – NYTimes.com
So how much evidence of a liquidity trap is needed to get the other side to re-think their flawed premises?