You should read Alan Blinder about "The Great Moderation" -- recessions since the late 1970s have been shorter and shallower than their predecessors. And far shorter and shallower than their counterparts under the gold standard in the 19th century. Also empirically, the reason the United States is doing better than Europe is because of the stimulus/bailout. It might be hard to think of the United States as a success story since it is only a relative one, but look at the much more dire situation in countries like Britain and Greece and Spain where governments were forced or choose to embrace austerity.

There is no reason the world cannot produce the same amount of goods as it was producing in 2007 - there are more rather than less people willing to work and the cost of borrowing money is very low. The only big outside constraint is energy costs, which are being offset by some fairly amazing reductions in the prices of alternative energy, including solar power.

So why the mess? The problem is a classic liquidity trap, a preference of investors for highly-liquid and safe assets that results in less money being spent in the private sector. This is visible in the way the borrowing rates of the Federal Government have fallen despite the best efforts of the Republican Party to drum up a debt scare the moment it fell from power and stopped spending the money itself.

Bailing out the banks did somewhat stabilize the banking system and probably prevented catastrophe. What remains necessary is getting out of the liquidity trap, which means increasing the amount of spending in the private sector. One way to do this would be having the government borrow at essentially zero cost and invest that money in public infrastructure projects which offer a return on investment. Another approach would be having the Federal Reserve declare an inflation target of 4% until the economic crisis is over. This would reduce the expected ROI from parking money in Treasuries and provide a greater incentive for firms to make private sector investments instead of just parking cash in the bank.

Yeah, well, I suppose I should admit don't buy the classic liquidity trap theory either. If you put a dollar into T-bills, you drive the interest rate a little lower, which causes, say, 70 cents of other investors' money to leave in disgust. Where do they go? To other assets.

And it's only 70 cents only because the suppliers of new debt, the US authorities, are sensitive to interest rates too. Investors can, net, only buy as much debt as the government is issuing, right? So if the Federal authorities are so worried about a liquidity trap, let them limit their debt issuance! If they do that, then your dollar put into Treasury securities means a dollar worth of other investors' leaving. No more liquidity trap. (At least as far as "highly-liquid and safe assets" == US govt debt. They could find other safe and liquid harbors, perhaps Japanese govt debt.) But the Feds aren't doing that, thus, I think that "having the government borrow at essentially zero cost and invest that money in public infrastructure projects" would in fact be bad for real wealth and prosperity because that borrowing brings some more money to T-bills and away from other investments, some of which would be private investments, for example. Of course if those projects are needed on their merits, not as make-work, then great, do them.

The same is true of your example of "parking cash in the bank". Parking cash in the bank means making investments. Where does the bank put it? They invest it. A bank is not a destination for money, it's a conduit.

What other assets?

This is why we have a new tech bubble: everyone is scrambling for somewhere to put their money, but none of them are willing to put it in the hands of consumers, which is the only place it will do any good.

This is why people are buying Treasuries like they're crack. Elasticity approaches zero when there is no substitute good.

I think I agree with you and am not sure where the disagreement is. Save possibly two points:

(1) Limiting debt issuance would only be expansionary if it didn't imply a reduction in government spending. And financing growth by expanding the money supply is a perfectly acceptable Keynesian solution. If this led to inflation and rising interest rates that would suggest the economy is no longer in a liquidity trap and the Fed could step in to rein in inflation while the government could go back to raising money on the bond markets.

(2) I'm under the impression that US banks reduced lending following the 2008 bailout. I seem to remember Andrew Ross Sorkin making this case, but either way - I don't think the best solution to the present crisis is a 20 year process of watching the banking sector delever as in Japan! Better to have controlled failures to wipe out debt and reduce moral hazard while making sure the economy is primed with the demand to deal with the fallout. How exactly to do that is a good question.

I mean I think there's no such thing as a liquidity trap, so I believe we disagree on that at least.

Regarding your point #2, yes I agree. But bailing banks out is exactly what Japan did. The certainty of regulatory capture by banks makes it better to just remove the government ability to bail them out. Let them fail. A moderate approach would be to limit bank mergers - too big to fail is too big.

Asserting that an economy is in a liquidity trap is equivalent to asserting that increasing the money supply will not drive up inflation or interest rates in the short term, but will drive employment and GDP growth.

I don't think it makes sense to argue that this situation is not theoretically possible since it appears to describe reality quite well. That said, the policy commitment that comes out of accepting even the possibility that we may be in a liquidity trap should be uncontroversial regardless of whether you believe the model is a close approximation of reality or not: push aggregate demand until there is some evidence it is driving up inflation and interest rates, at which point the theory says to stop because more of the same won't do any better.

At today's interest rates a bank is a destination in the minds of depositors. It merely is holding value and preventing a loss in nominal terms.

Do you have evidence that people are leaving T-bills in disgust and investing in other assets?

Simply the fact that you can buy them in secondary markets.

I only want to point out the absurdity of your first sentence "recessions since the late 1970s"

So the timeline for your analysis is ~30 years? That is not convincing to me, this current recession is already going on 4 years and shows no signs of stopping. The extreme cherry picking of data and reasoning like yours is exactly why I stopped studying economics in college, but hey at least you were able to throw in some partisan politics in your post right?

Back when I was in graduate school, the general belief around the economics department was that the unemployment rate was whatever Alan Greenspan wanted it to be, plus or minus a bit to account for the fact he was not God. So I didn't invent the term "Great Moderation" and you have a lot of reading to do if you think the phenomenon it describes has anything to do with me.

On your second point, it's hardly partisan to point out that Republicans have consistently raised the specter of a debt crisis and soaring interest rates to attack the feasibility of further monetary or fiscal stimulus directed at anything but the banking sector. Or even at the banking sector (it wasn't Democrats who derailed the first bailout vote). And yet during this time US borrowing costs have fallen to the point where the ten year rate is now basically below expected inflation and everything points to the United States being caught in a liquidity trap. People are even paying the US government to hold money at a loss!

http://www.marketwatch.com/investing/bond/10_year/charts

I don't know why someone pointing this out should hurt your feelings, since your complaint is with reality. It might feel nice to think that this is a partisan instead of a policy critique, but harping at me isn't going to make Republican economic policy less destructive or make the bond market change direction.