While the Great Depression occurred almost 80 years before the Great Recession of 2008 and decades before the start of Japan’s Long Recession, the three economic crises share striking similarities. Economists from Brown recently published a paper reviewing the three episodes and presenting a unifying framework for understanding them.
In the paper, Professor of Economics Gauti Eggertsson, along with Sergei Egiev MA’18 PhD’24, analyzed how “liquidity traps” — which occur when plummeting interest rates become ineffective in stimulating economic output — are a unifying thread across the three economic crises.
Eggertsson’s paper explaining this theory is a culmination of research he’s conducted over the past 25 years, he said.
“Every financial crisis has new elements, but there is also a startling degree of continuity,” Professor of Economics David Weil, who was not involved with the study, wrote in an email to The Herald.
Two of the key similarities between these events are how they begin — the “trigger” or shock — and how they get resolved, according to the paper.
Eggertsson compared the run-up to an economic crisis to a cartoon character who runs off a cliff, but “the law of gravity doesn’t start applying until he looks down.”
At some point, households, companies and banks realize they are overextended in debt and cut their spending, slowing the economy, according to Eggertsson. To revive economic output, the central bank can cut interest rates to make it easier for people to access money that is cycled back into the economy.
But when these interest rates approach zero and cannot be lowered any further — called the “zero lower bound” — “conventional monetary tools” are no longer effective, according to the paper.
According to Eggertsson’s paper, the liquidity trap does not mean the central bank “can do nothing.” Instead, the government must work to change expectations, he said. This is “a less pessimistic view of the effectiveness of monetary policy,” the paper reads.
Sebnem Kalemli-Özcan PhD ’00, a professor of economics who was not involved with the paper, wrote in an email to The Herald that Eggertsson’s paper “packages the liquidity trap literature into a teachable framework.”
For example, the paper focuses on President Franklin D. Roosevelt’s monetary policy during the Great Depression. During the economic crisis, Roosevelt committed to increasing inflation to encourage spending and bank deposits, which would in turn stimulate the economy.
Even the expectation of inflation can boost the economy, according to Eggertsson. If consumers “expect 10% inflation, sitting on money is a lousy proposition” because the products would lose 10% of their value to purchasers, he explained.
Eggertsson’s interest in monetary policy came from his desire to have an “impact on the real world,” he said. Monetary policy is “very special” because decisions — like the ones he made while working at the Federal Reserve Bank of New York during the Great Recession — lead directly to impact.
Macroeconomic crises cause a “huge amount of suffering,” Weil wrote. “So studying what causes them and how policy can best respond is of enormous importance.”
“You screw up, you can have a Great Depression,” Eggertsson said. “If you don’t, you can avoid it.”
Nishita Malhan is a senior staff writer covering science and research.
