...much like the Pirate's Code.
At least I think it is. Jonathan Catalan, in commenting on a page for Steve Horwitz's Great Depression class, brings up the liquidity trap in thinking about Keynesian policy responses, as well as Keynes's doubt that it was even binding in the Great Depression. The point (he can correct me if I'm wrong on interpreting him) was that if there was no liquidity trap in the Great Depression then there was no case for fiscal stimulus and even Keynesians agree fiscal stimulus can't work.
This seems wrong to me, and in a way it's related to the hand-waving that the market monetarists do.
Fiscal stimulus gets attractive relative to monetary policy when monetary policy loses some of its oomph, namely, when it looses the interest rate channel and has only the expectations channel to rely on. Expectations may be tough to move so non-market-monetarists think fiscal policy has a shot at stepping in and really making a difference.
This is a guideline for why fiscal policy is particularly important in a liquidity trap, but it's hardly a proof of the inoperability of fiscal policy outside of a liquidity trap. That requires something extra.
Essentially it requires assumptions about the monetary policy reaction function, some very clear demarcations of what we mean by "fiscal multiplier", and the assumption that monetary policy can always meet its target (the last one is probably fine outside of a liquidity trap).
Noah Smith once summarized this interpretation (a third of three possible interpretations) of assuming fiscal policy had a zero multiplier in this way:
"Possible Claim 3: Because the Fed can, in theory, counteract any fiscal stimulus, the effect of any fiscal policy on output should be considered to be zero.Think about it - if fiscal stimulus can't work outside of a liquidity trap then why do we think automatic stabilizers are a good idea? Why do we have these lines like "you have to balance the budget over the cycle" (wrong, technically - you have to stabilize the debt over the cycle you never have to balance the budget but you get the idea).
Possible Claim 3 has two parts - a definitional part, and a theoretical part. First, it says that (3a) when we talk about the "multiplier" associated with fiscal stimulus, we should include the Fed's reaction function in the model that we use to estimate the multiplier. This is the argument made by David Romer in some remarks cited by Sumner:
As Robert Solow stresses in his remarks in this session, we should not be trying to find “the” multiplier: the effects of fiscal policy are highly regime dependent. One critical issue is the monetary regime...if [central banks are] successful [at offsetting the effects of fiscal policy], one would expect the estimated effects of fiscal policy to be close to zero.This is just saying that there are several ways to define "the multiplier" - you can talk about the multiplier while holding monetary policy constant, or you can talk about the multiplier in the context of a model that includes the Fed's reaction function. If we look in the data and see that a fiscal stimulus was followed by an increase in nominal output, we could say that "The stimulus increased output," or we could say that "The Fed increased output by choosing not to counteract the stimulus." To borrow an old NRA slogan, it's a question of whether guns kill people or people kill people.
BUT, aha! Possible Claim 3 also involves a theoretical claim. This is the claim that (3b) the Fed's reaction function is invariant to fiscal policy! To see why, consider a world in which the Fed targets a 3% growth rate for NGDP if there is no stimulus, but raises the growth rate target in the event of a stimulus. In this case, it would make perfect sense to say "fiscal stimulus increased NGDP growth," in the sense that we normally think of causality. It would make no sense to attribute the growth increase to the Fed. That would be like saying "You think you put butter on that piece of toast, but actually it was I who put butter on that piece of toast, since I could have clobbered you on the head and stopped you from putting butter on the toast, and I chose not to. Thus, you are incapable of buttering toast; only I can butter your toast." That would be a truly batty claim!"
We know fiscal policy works outside of a liquidity trap, we've just gotten so caught up in monetarist sensibilities that (1.) monetary policy is all-powerful and even more importantly (2.) monetary policy must be treated as a part of the economic system (hence the monetary policy reaction function) and not as another exogenous policy lever that we say silly things like "fiscal policy doesn't work outside of a liquidity trap".
I'm not saying we should toss monetary reaction functions out the window. There's a very good reason why they've superseded LM curves and why we might want to think about them as being in a sense more "natural" than fiscal policy. But when we make claims about the efficacy of fiscal policy we need to think more about exactly what assumptions we're making when we toss in an MP curve.
So the moral of the story is that the liquidity trap "rule" is really more of a guideline than an actual rule.
Fiscal policy works, period. But as a matter of practice you might want to be judicious about using it and you might want to let liquidity traps guide that use.