Inflationistas And Deflationistas: [I]t’s worth bearing in mind that the last year and a half has been a fairly clean test of alternative views about how the economy works. When the economy slumped, budget deficits skyrocketed, and the Fed began large-scale asset purchases, there were two kinds of people.... On one side were people who said that deficits would drive interest rates way up, crowding out private investment, and that all that money printing would lead to high inflation. On the other were those who said that we’d entered a Japan-type liquidity trap, which meant that (a) there was a savings glut, so deficits would not crowd out private investment and interest rates would stay low, (b) increases in the monetary base would just sit there, (c) the risk was deflation, not inflation.
And so far, the inflationistas have been completely wrong, the deflationistas completely right.
This wasn’t a coincidence. For the most part, the inflationistas basically argued that nothing changes when the economy is depressed and short-term interest rates are up against the zero lower bound: the quantity theory of money still rules, and interest rates reflect supply and demand in the loanable funds market. The deflationistas knew — based on study both of Japan and of the 1930s — that everything changes when you’re in the liquidity trap. And recent experience shows just how true that insight is.