I think Paul is too quick to dismiss this idea

Here’s what we already know: in the looking-glass world of the liquidity trap, supply-side improvements are generally counter-productive. I know that sounds weird, but that’s what liquidity trap economics is like. A few years ago Gauti Eggertsson identified the “paradox of toil”; in our joint work we sketched out the related “paradox of flexibility”.

The basic point is that the aggregate demand curve is actually upward-sloping, because any fall in prices does nothing to reduce interest rates but does increase the real burden of debt. So making wages more flexible, say, does nothing except worsen balance sheet problems.

So how does the Vox paper get a different story? By assuming that the payoff to supply-side improvements doesn’t come until the economy has already spontaneously emerged from the liquidity trap, and so these perversities are gone. The idea then is that consumers, rationally perceiving this future improvement, feel richer and spend more now.

A couple of things

First, Even under the logic of Eggertsson and Krugman (E&K) its not necessary that the supply-side event occur after the liquidity trap is over, it just has to last beyond the trap. The wealth effect would be brought forward by an increase in asset prices, which increases the desire to consume today.

The other issue is that in the E&K framework the core issue is that there are borrowers and savers. When a crisis hits the borrowers need to repay the savers but if we hit the zero lower bound the borrowers have no way to get the savers to accept the payment

That is, the way borrowers repay savers is by consuming less so that the savers can consume more. However, the way you get savers to consume more is by lowering the interest rate. If the interest rate can’t go any lower then the savers won’t consume more. Hence, the borrowers have no real way to repay them.

The borrowers have to “act like” they are repaying the savers by consuming less. But, no repayment actually happens because the savers aren’t consuming more. Thus, we are stuck in under-consumption.

One feature of this model is that it has no capital. Thus, borrowing and lending only takes the form of one person agreeing to consume less today, so that the other person can consume more tomorrow. No savings is used to grow the economy as it were.

Now, so long as the marginal return to capital is driven to zero by the deleveraging shock this is fine. This could happen both because the supply of loanable funds increases rapidly or because the marginal return to capital at all levels fall due to slack demand.

However, if a supply side improvement raises the marginal return to capital then it has the potential to bring you out of this funk.

Indeed, this is exactly how we think the liquidity trap will end anyway. Either technological improvement will raise the marginal return to capital and pull the economy out, or the size of the capital stock will fall due to depreciation so that the economy is pulled out.

A supply-side improvement brings this point in time forward.

So, even if we don’t think its enough to immediately end the liquidity trap it should shorten it.