Bruce Bartlett has a very nice summary of Keynes’ thinking on liquidity traps and the need for stimulation:
What Keynes figured out is that when conditions such as these exist, the federal government must step in to raise spending in the economy and thereby increase velocity. This means running a budget deficit, but that is only part of the solution [...] Keynes argued that the only thing that will really work is if the federal government uses its resources to purchase goods and services. It must buy “stuff”–concrete, computers, paper, glass, steel–anything as long as it is tangible. In other words, the government must spend the way households do, by buying things. It must also employ labor, because much of what people spend money on today is in the form of services [...]
At this point, Federal Reserve policy will become effective again. As prices and interest rates rise, the liquidity trap disappears and money begins circulating more rapidly; i.e., velocity increases. This is what ends an economic crisis. Unfortunately, it was not until World War II that the federal government spent enough on real resources–because they were needed for the war effort–to make Keynes’ theory work in practice. [...]
For what it’s worth, Keynes didn’t know what to do in this situation, either. He suggested building pyramids and burying bank notes in deep mine shafts that had been filled in. As people tried to dig up the money, they would be forced to employ labor and purchase equipment that would raise spending and thereby growth. In the end, it took the greatest war in history to make Keynes’ theory work.
I think that mine idea is pretty clever. But obviously the better answer is SUPERTRAINS. In particular, whenever I start prattling on about high-speed rail, people point out that it would cost an ongodly sum of money. But in our current crisis, one of our main problems is a lack of non-ridiculous ideas about things to spend money on. For example, it turns out that the total cost of “ready to go” infrastructure projects in this country is valued at tens of billions of dollars rather than the necessary hundreds of billions. That’s because planning was done in the old “how will we find the money” world. At the moment, we’re in a weird “how will we find things to spend money on” world. Under the circumstances, one thing I’d be doing if I were president is dedicating a small slice of the 2009 stimulus making sure that we get a big and absurdly expensive list of high speed rail projects “ready to go” in some sense by 2010. Hopefully, by then the economy will be back on the path to recovery in which case interest rates will be back at a level where we don’t necessarily want to engage in huge gargantuan deficit spending. In that case, most of those plans will have to be shelved. But if not, some can roll forward.