I’ve often argued on this blog and in the column that now is a particularly bad time to cut spending, because unlike in normal times, the adverse effects on demand can’t be offset by cutting interest rates. One way to highlight the point is to compare where we are now with a historical episode: the fairly large cuts in federal purchases of goods and services that took place in the early 1990s, as the US military shrank with the end of the Cold War.
And shows a version of this chart as “witness for the defense”:
The Fed could and did cut rates, helping to cushion the impact of spending cuts. It can’t do anything like this now, because the Fed funds rate has already been cut more or less to zero in an attempt to fight the effects of financial crisis.
But note that in the second half of the period, interest rates went up (doubled) and government consumption as a share of potential output kept trending down. You could suppose growth “crashed”. But that was definitely not the case as seen in the chart below:
My take is that “Keynesians” are terrified about finding out that even if government purchases are reduced output can increase if monetary policy ‘so desires’. They would ‘lose face’ on two counts:
- The liquidity trap is a myth
- Monetary policy is powerful even at the ZLB (a.k.a. ‘LT’)
Though even if sometimes Krugman pays lip service to the need for more ‘aggressive’ monetary policy, he quickly falls back to his default position: if G is decreased, we´re ‘doomed’ because monetary policy IS interest rate policy, and rates are at zero!