Every major economic downturn of our lives has been met with making it cheaper to borrow money.
It works. The economy gets too slow, the Fed cuts rates. The economy starts producing too much inflation the Fed raises rates.
Unfortunately we have had a low-inflation environment since 1980. This has kept wages flat, led to bubbles aplenty and ultimately led to a Fed unable to effectively fight a major crisis.
When this thing started the Fed rate was only 2-3%. This was a catastrophic event that would have been met by at least 8 % points of rate cuts. We are supposed to be at –5% or –6%, but that is impossible.
As a result, money is far too expensive. Don’t be fooled by the record low rates. They are not actually cheap rates relative to the economic environment because nobody expects the economy to grow much for a decade and people are worried about deflation.
Here is the formula for the cost of borrowing money:
(Interest Rate) – (Inflation) = Real cost of borrowing
When the interest rate side hits zero like the Fed rate has then there is no way to make borrowing cheaper without increasing the inflation variable AND keeping the interest rate the same. (0%)
This post is offered as background to this Krugman entry:
http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=389x9062412
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