When smart people say something that seems wrong it’s a good idea to think you’re missing something. Yet, the possibility of correcting Krugman and achieving international (or at least intra-household) fame is too much to resist.

Krugman says

Some comments on various blog posts ask what evidence we have that liquidity trap economics is any different from normal economics. Um, the answer is staring us in the face: the failure of interest rates to rise despite very large budget deficits:


The problem here is that large budget deficits should drive expansion and expansion should drive up long rates.

Suppose that the economy was in a depression because there is a savings glut. Then the government announces that it will sop up the savings glut and end the depression. This should raise expectations of future growth which in turn should raise long term interest rates.

We could think about this through the monetary channel and say, large budget deficits should decrease the amount of time the Central Bank is up against the zero lower bound and thus raise the path of short interest rates. Through arbitrage long interest rates should give the same yield as the path of short rates.

So wouldn’t the failure of long rates to rise in the face of an expanding deficit be evidence that deficit spending is not going to work?