Whilst I regard the work of Paul Krugman on liquidity traps as seminal, I am not convinced that simply focusing on the liquidity - or viscosity - trap is the best available strategy. None of the proposals for 'escape' convince me, partly because I feel they do not resolve the fundamental problem of 'expectations', that is the problem of the chicken and egg situation: we will only escape when we believe we can escape, we will only get 'lift off' when we believe we have lift off, and we will only do either, or both, of these things, when we ourselves are convinced we have a path which isn't 'simply foolin around'. Wasn't it Churchill who said, you can fool some of the people all of the time (they must be the foolish of 'foolproof path' fame) or all of the people some of the time, but what you can't do is fool all of the people all of the time. To achieve this lift-off 'convincingly' we need to have a strategy that convinces. Simply following the advice of attempting to have a universal devaluation (despite the IMF's declarations to the contrary, global deflation is what we may be facing) - the 'so called' foolproof path - ,or of 'commiting to being irresponsible', falls down on the principle test: these proposals fail to convince. The problem with the 'liquidity trap' type analyses is that they look at the effect not the cause.
Here references to Keynes do not help us too much, since he was writing while we were on the ride up, and we are trying to cope with the beginings of the ride down (in the end we're all 'free riders', but there's no 'easy-rider' solution, Ughh!). If we don't get to grips with the relationship between human reproduction and ideas, we're going nowhere fast. Having said all this, orthodox viscosity trap analysis is remarkably unimaginative in its solutions. The technology of money has changed a lot since Keynes' time, and there are proposals to make use of these changes. The latest joint effort by Woodford and Eggerston, notices this, but, after an approving nod, moves on. Why? Because such proposals will attract political opposition. This is really the heart of our present difficulties. Few are prepared to grasp at solutions which may really offer (at least temporary, vital, time-buying) solutions, since the political opposition may be to strong. The globalisation of labour, and positive affirmation of immigration is another clear case in point here. So we are left with 'pension reforms' (read reductions)and the dismantling of welfare. Are these more political popular, it depends on which circles you move in, and what sense of vision you have, I suppose. Oh, never mind.......
We do not here explore the possibility of relaxing the constraint by taxing money balances, as originally proposed by Gesell (1929) and Keynes (1936), and more recently by Buiter and Pani..... (1999) and Goodfriend (2000). While this represents a solution to the problem in theory, there are substantial practical difficulties with such a proposal, not least the political opposition that such an institutional change would be likely to generate. Our consideration of the optimal policy problem also abstracts from the availability of fiscal instruments such as the time-varying tax policy recommended by Feldstein (2002). We agree with Feldstein that there is a particularly good case for state-contingent fiscal policy as a way of dealing with a liquidity trap, even if fiscal policy is not a very useful tool for stabilization policy more generally. Nonetheless, we consider here only the problem of the proper conduct of monetary policy, taking as given the structure of tax distortions. As long as one does not think that state-contingent fiscal policy can (or will) be used to eliminate even temporary declines in the natural rate of interest below zero, the problem for monetary policy that we consider here remains relevant.
Meantime Joerg writes with his own sense of vision, taking as his starting point and inspiration my recent post on the Monarch butterfly.
Here is a little metaphor - rather baroque, I will admit, but I just could not resist: Like the circadian clock and the sun compass ensure that the monarch butterfly manages to navigate its path to survival, humans rely on coordinating their calendars and agendas to optimize economic results. Constant light causing the monarchs´ circadian clock to malfunction might seem akin to the "liquidity trap" at the zero bound of interest. Flying straight into the sun then is the monarchs´ way of attempting to keep their cash indefinitely. Similarly, without leverage to further its multiple agendas, human society skids along on the flat plane of horizontal time...
That is where I think the Post-Keynesian recipe of introducing a penalty on liquidity should be followed. There are two ways to conceptualize the situation:
1) Non-neutral money - the Keynesian/Post-Keynesian assumption. Technically, there are no fundamental obstacles keeping it from being implemented. When everything else will have failed, there is going to be a consensus for a renovatio monetarum: money that is automatically devalued at regular intervals. The ECB is talking about using RFID chips on Euro notes in the fight against counterfeiters. If that generation of money fails, new notes - equipped with more RAM - may need to be introduced (Keep them regularly updatable, I would say...). We might be en route to money that "ages" - relieving the stress society is supposed to undergo from a "deteriorating" age composition by increasing velocity significantly.
2) Neutral money - the monetarist framework. It implies acceptance not only of deflation but probably depression, too. A new equilibrium would finally occur after massive reductions of prices - including wages. There might be a flight to gold - even a remonetization of gold. Quite a few Austrians are looking forward to the Dow and gold crossing their paths - downwards and upwards resp. - at about 3000 or lower... (definitely a price level where marking gold to market and then remonetizing it
is feasible). There can, however, be no doubt that micropayments will be a feature of the future. Even with gold as base money we would still witness the introduction of software money to handle the vast increase in transactions involving small amounts.
Regular revaluation and gold have historically provided the two most stable monetary systems: Ancient Egypt operated on depreciating money for 1600 years - until the Romans took over Egypt. Byzantium managed to achieve 800 years of price stability under a gold standard. Intuitively, I cannot imagine why initially randomly distributed gold should be reinstituted as money. But if we are really headed for a gold mania, then the Asian markets will be soaking up gold like a dry sponge. There can be no doubt that western central banks should keep their gold - rather than sell it all off in a futile attempt to stem the tide of a gold price rise that might certainly go higher than the previous high somewhere beyond 800$.