We should not be in this economic mess. In 1930, the United States had a string of bank failures that set off the Great Depression. The economy struggled for a decade. John Maynard Keynes, who had made a name for himself by correctly predicting what would happen to the German economy after the First World War in The Economic Consequences of the Peace, turned his attention to the Depression in The General Theory of Employment, Interest, and Money, published in 1935.
Keynes warned of a liquidity trap, which happens when consumers save all of their money, instead of using it to invest or consume. The supply of cash gets huge, relative to demand, so interest rates go down to practically nothing. But everyone is too scared to invest or consume. So everyone just keeps saving. Although prices fall, consumers believe that they can get a better deal by waiting a little longer. Businesses have the funds to invest and expand, but they figure it will be better to wait until customers spend money again. Meanwhile, interest rates drop even more as cash balances rise.
It becomes a vicious circle.
Gross Domestic Product is the total of consumption, investment, government spending, and net exports. You often see it written as C + I + G. Keynes said that if consumption and investment are too low to get the economy moving, the best option is for the government to spend money, even if it has to use deficit spending to do so. Roosevelt's New Deal was a model. The government established programs like Social Security so older Americans would have money to spend, and it launched huge infrastructure projects under the Works Progress Administration to build roads, national parks, and post offices. It even set up programs to hire artists. The WPA post office in my neighborhood boasts a marvelous WPA mural.
Keynes fell out of favor in the United States in the late 1970s and early 1980s -- not because he was wrong, but because of concerns government spending was crowding out consumption and investment. Somehow, though, this was twisted into a general belief that Keynes was bad and evil, and besides, the Depression was one of those things that would never happen again. Of course, the response was to cut taxes but not government spending, as everyone loves government programs as long as they don't have to pay for them.
Meanwhile, the Japanese economy in the 1980s was hotter than a Chicago summer... until the real estate bubble collapsed there. This took down many Japanese banks, although the government kept the failed banks open anyway. People put all their money in cash because they were scared to invest or consume, even though interest rates kept going down. The government spent its capital propping up businesses and banks that deserved to fail. The liquidity trap that Keynes warned about proved true.
In deflation, prices and interest rates fall. You don't actually see negative interest rates. Instead, service charges go up. In Japan in the 1990s, banks started charging fees for safekeeping instead of paying interest, because a bank is a better place for money than a mattress, yes? Last week, the Bank of New York Mellon Corp. (NYSE: BK) announced it was doing the same for its largest customers. Good luck trying to find free checking anywhere in the near future. It'll likely be a perk only for those who carry huge balances or who agree to frighteningly large ATM fee schedules.
We are in a liquidity trap, ladies and gentlemen. The sad thing is: We didn't have to be here. Even worse: We're not getting out any time soon. Americans are tapped out, and 9.1% of us are unemployed. We're not consuming. Businesses could invest, but they aren't, at least not here. Instead, they're carrying so much cash that the Bank of New York Mellon is charging fees to pay for guards, safes, and network security. What we should be doing now is what we should have started doing as soon as the financial crisis hit: spend big government money on infrastructure projects, even if we had to raise taxes to do it.
Look, cutting taxes now won't stimulate investment. Even with negative interest rates, companies aren't investing. "Job creators" aren't creating jobs. Heck, it may be cheaper to have taxes go up a percentage or two than to pay service charges on all that cash stuck in the bank.
But we didn't do that, because of a combination of greed, economic illiteracy, and intransigence. Hence, ratings agencies are downgrading our debt, and we're getting a few more years of recession.
Back in the early 1980s, my high school chemistry teacher would admonish us for taking sick days. He didn't believe in school holidays, either. "There are a billion Chinese waiting to take your seat," he would say, and we would all laugh.
He was right.