May 27 (Bloomberg) -- Just when you thought deflation was the scariest thing on the horizon, along comes the phony specter of a new threat: a liquidity trap.

In case you're unfamiliar with this concept, its origin owes to the dead British economist John Maynard Keynes, who theorized about the inability of near-zero interest rates to revive the U.S. economy -- restore it to full employment -- during the Great Depression.

As explained by economist Paul Krugman in his New York Times op-ed column on Saturday, when interest rates fall close to zero, ``additional cash pumped into the economy -- added liquidity -- sits idle, because there's no point in lending money out if you don't receive any reward,'' Krugman said. ``And monetary policy loses its effectiveness.''

Krugman, a frequent critic of the Bush administration, warned that the risks of falling into a liquidity-trap ``quagmire'' were high (the Schadenfreude was palpable).

Perhaps Krugman should read the speeches of his former Princeton colleague, Fed governor Ben Bernanke. While it's true that nominal interest rates can't fall below zero, the thrust of monetary policy isn't defined by the level of the overnight rate, which is the chosen policy instrument for most central banks. Even when a central bank faces what the Federal Reserve refers to as the ``zero-bound policy constraint,'' it still has an unlimited ability to print money.

Not Zero-Bound

OK, you say. The Fed can print money, but the banks, which get deposits when the central bank buys Treasury securities in the open market, don't have anyone to lend it to. So there is no multiplier effect to energize the Fed's monetary stimulus.

Wrong. Even when the private sector has no demand for credit, which is hardly the situation today, there is one entity with a voracious appetite: the federal government. With the federal deficit likely to hit $400 billion this year, there's no lack of government bonds for the Fed to buy.

Nobel laureate Milton Friedman used to tell his students at the University of Chicago that as a theoretical argument, the liquidity trap didn't make much sense since the central bank can always expand the money stock. When the central bank puts out more money than the public wants to hold, at the margin someone will spend it.

As a practical matter -- as an explanation for the Great Depression -- Keynes's liquidity trap didn't cut it for Friedman either. The Fed allowed the money supply to contract by about a third, which for him was the cause of the protracted period of declining economic growth, wages and profits.

Soggy String

The idea of a liquidity trap is often expressed by the metaphor of the central bank ``pushing on a string.'' This diagnosis gets recycled whenever the economy isn't responding to low interest rates in the prescribed manner.

The liquidity-trap myth made a comeback in the early 1990s when the U.S., faced with a dysfunctional banking system, required an extended period of low interest rates first to heal banks' balance sheets and second to produce a response in the real economy.

Japan has provided a decade of delight for liquidity-trap theorists. Interest rates in Japan are near zero, economy-wide prices are falling (as opposed to some prices in the U.S.) and the economy is dead in the water.

Unfortunately, the diagnosis is incorrect.

``No country has ever been in a liquidity trap,'' says Allan Meltzer, professor of economics at Carnegie Mellon University and visiting scholar at the American Enterprise Institute. ``Japan is not in one now. Neither is the U.S.''

Misguided Policy

Falling prices and interest rates in Japan say more about mistaken monetary policy than anything else, Meltzer says. The Bank of Japan has the ability to buy more assets, which would increase money growth -- Japan's broad money supply is up a scant 1.4 percent year over year -- and end the deflation.

If the Japanese government ever got serious about cleaning up the banking system -- forcing the banks to write off bad loans, forcing insolvent banks to close -- the BOJ would get some help in its effort.

As far as the U.S. is concerned, Meltzer, who is the author of a new 848-page book, ``A History of the Federal Reserve, Vol. 1: 1913-1951,'' points to several periods when interest rates were at or close to zero, without any liquidity getting trapped.

``In 1954, interest rates were 0.5 percent or below, and we had no problem recovering,'' he says. ``In 1948 to 1949, we had zero interest rates. Also in 1937 to 1938. We had no problem recovering.''

Pink Parrots

Meltzer is equally dismissive of the deflation threat.

``We just reported a GDP deflator of 2.5 percent'' in the first quarter, Meltzer says. The implicit deflator measures price changes in the gross domestic product.

The highest reading in almost two years hasn't stopped a flood of talk and articles on the dreaded deflation ever since the Fed mentioned the risk of falling prices in the statement following its May 6 meeting.

``If Alan Greenspan said the grass is pink, Wall Street economists would see pink grass,'' Meltzer says. ``I like Alan Greenspan, but they all speak as if he's the Oracle of Delphi.''

The Fed chairman hasn't voiced any concerns about a liquidity trap just yet. To the contrary, like Bernanke (and unlike Krugman), he's talked about instituting ``unconventional policy measures'' -- buying long-term bonds -- should the overnight rate hit zero.

And if that doesn't work, I'll bet he has a few strings he could pull (or push).

Last Updated: May 27, 2003 14:06 EDT