Last winter, America's central bank - the Federal Reserve - was busy patting itself on the back. The Fed's cut in its basic interest rate to 1.75% per year seemed to have worked: the recession was ending. Despite sobered expectations about the high-tech revolution's impact on productivity and profits, as well as the jitters inspired by the terror attack on the World Trade Center, American businesses, it was believed, would soon start investing again big-time because borrowing money at 1.75% was too good a deal to pass up.
By late spring, those expectations had disintegrated alongside the collapse of Enron, WorldCom, and Arthur Andersen. Suddenly, everyone doubted the integrity of the financial accounts of American companies. Suddenly, everyone saw just how much America's system of corporate surveillance and control had deteriorated during the bubble of the 1990s.
The American stock market fell 15-20% below its winter levels. Spreads between the interest rate at which America's government could borrow and the interest rates at which America's corporations could borrow widened. Suddenly, the Fed stopped congratulating itself: a 1.75% interest rate might be the right interest rate to fuel a recovery when the Dow-Jones stock market index stands at 10,000, but not when the Dow-Jones index stands at 8,500.
Throughout the summer, corporate investment news remained disappointing. More and more analysts began to speak about the possibility of a "double dip" recession.
Yet throughout all this, the Federal Reserve remained passive. The short-term interest rates it controlled didn't budge. Only in mid-August did the Fed hint that interest rates might be cut.
The informal and unofficial rationale leaking out of the Fed for its inaction had two parts. First, short-term interest rates were already so low that everyone would see further cuts as temporary only. They would thus have little effect on the longer-term rates that really drive business investment.
Second, short-term interest rates were so low that additional cuts would spook the financial markets: if even the Fed thought conditions warranted cuts, the argument went, businesses would respond not by increasing their investments but by reducing them. The Fed's judgment appeared to be that it was largely (if not completely) powerless: it had done all that it could, and the levers of monetary policy were no longer strongly connected to determining the level of economic activity.
So the US in 2002 joined Japan in what economists have for sixty-five years called a Liquidity Trap: a situation in which the short-term nominal interest rates the central bank controls are so low and so loosely connected to the level of aggregate demand that further reductions are ineffective in fighting a recession.
America's situation was not unique: Japan had been in been in thrall to a liquidity trap since the mid-1990s. But there had been no other examples since the Great Depression of the 1930s.
Whether America now really is in a liquidity trap is uncertain. How long this state of affairs will last is unknown. Nevertheless, even if America is only on the edge of a liquidity trap, and even if it moves away from the current state of affairs soon, this is a frightening situation. If monetary policy is not effective, the only lever the American government has to manage its economy is fiscal policy: changes in the government's tax and spending plans to change the government's direct contribution to aggregate demand.
But the lesson of the decades since World War II is that the US government - with its complex, baroque, eighteenth-century organization - is incapable of changing policy fast enough to make effective use of fiscal policy as a tool for managing the economy. It simply takes too long for changes in taxes and spending to work their way through Congress and the bureaucracy. An America caught in a liquidity trap is, quite simply, a country with no effective tools of macroeconomic management.
There have been two eras since World War II when policymakers - American policymakers, at least - believed that they had solved the riddle of the business cycle and had learned how to manage a modern industrial or post-industrial economy. The first was the Keynesian high-water mark of confidence in demand management of the 1960s. It was destroyed by the inflation of the Vietnam era and the oil-price shocks of the 1970s. The second was the decade of successful business-cycle management by Alan Greenspan's independent, apolitical, and technocratic Fed during the 1990s. This second era now appears to have been as fleeting as the first.
Eighty years ago, John Maynard Keynes argued that governments needed to take responsibility for maintaining full employment and price stability - that the pre-World War I gold standard had not been the golden age people thought it was, and that its successes were the result of a lucky combination of circumstances unlikely to be repeated.
Keynes was an optimist in believing that governments could learn to manage the business cycle. He would be shocked to look at today's world: a Europe with stubbornly high unemployment, a Japan mired in a decade of near stagnation, and now an America lacking the policy tools to deal with any additional unexpected economic bad news.