Living In A Black Hole, Or Life At The Zero Lower Bound

Keynes developed his general theory during the Great Depression.  In a sense, the economy was in a black hole from which it was unable to escape with classical economic theory.  He called this black hole the liquidity trap.  We are in a similar situation today.  After taking on too much debt, many households and firms are paying off their debt instead of spending and investing.  Paying down debt is a form of savings.  Ordinarily, when the supply of savings increases, the interest rate falls.  That should stimulate investment and consumption to absorb the savings.  Unfortunately, interest rates are close to zero, but the level of interest rates would have to be negative to reduce the excess supply of savings.  Since nobody wants to make loans at negative interest rates we hold on to cash.  We are at the zero lower bound in which interest rates can't fall far enough to absorb the excess savings. 

One way to absorb the excess savings is to have a depression.  GDP or national income falls and savings fall with the decline in income.  Keynes did not believe that depression was the best way to deal with an economy that was at the zero lower bound.  He argued that government should borrow the excess savings and increase spending.  That would provide income to households and businesses that would increase private spending.  The goal is to produce a full-employment economy.

This topic has become current because government debt has risen and because the Fed and other central banks have reduced short term interest rates to the zero lower bound (real interest rates are negative when corrected for inflation).  Efforts are underway in many countries to reduce government spending, and some are calling on the Fed and other central banks to raise interest rates.  According to Keynesian theory, the result of those policies would be continuing depression and high unemployment.