Little Difference
But when rates become so low that there's little difference between cash and short-term government bonds, open-market operations cease having an effect; they simply swap one zero- yielding government asset for another, with their hunger to hold more safe, liquid assets unsatisfied.
This is the liquidity trap.
In this situation we need deficit spending. The government spends and borrows, creating more of the safe, cashlike assets that private investors want. As these bonds hit the market, people who otherwise would have socked their money away in cash -- diminishing monetary velocity and slowing spending -- buy bonds instead. A large, timely government deficit thus short- circuits the adjustment mechanism, avoiding the collapse in monetary velocity.
Hicks's conclusion: As long as output remains depressed and there is slack in the economy, printing more bonds will have negligible effect in increasing interest rates.
Special Case
I had read Hicks. I even knew Hicks. But I thought that his era, the Great Depression, had passed. Sitting in my first graduate economics class in 1980, I listened to Marty Feldstein and Olivier Blanchard -- two of the smartest humans I am ever likely to see -- assure me that Hicks's liquidity trap was a very special case, into which the economy was unlikely to wedge itself again. Yet it did.
On my shelf is a slim, turn-of-the-millennium volume by Paul Krugman titled "The Return of Depression Economics." In it he argued that we mainstream economists had been too quick to ditch the insights of Hicks -- and of economists Walter Bagehot and Hyman Minsky. Krugman warned that their analysis was still relevant, and that if we dismissed it we would be sorry.
I am sorry.
(Brad DeLong, a former deputy assistant secretary of the U.S. Treasury, is a professor of economics at the University of California at Berkeley, where he is chair of the political economy major. The opinions expressed are his own.)