Why I don’t believe in liquidity traps

by on January 15, 2007 at 6:04 am in Economics | Permalink

The core idea is that the government prints more money but people just hold it.  If nominal interest rates are low, OK, maybe no one wants to buy more bonds (however under some assumptions this will lower bond prices and raise rates again, bonus points if you can work through the whole analysis with real and nominal rates and price level paths).  But they will buy more goods, thereby stimulating aggregate demand.  If they won’t buy more goods, just print even more money.  The spending impulse will kick in. 

For another view, Paul Krugman argues people may not expect the inflation to continue for long enough, and therefore won’t spend their money but will instead expect a future deflation further down the road.  I think that creating and maintaining the inflationary expectations is quite easy, especially if the inflation will boost output and employment and thereby make politicians popular with voters.  If you print money, people don’t think "hmm…that is inflationary…that means someday the central bank will have to deflate, I’ll wait six years and spend this new money when prices are really low."  Yes, I see the intertemporal equilibrium concept, but nope, that fails Psych 101.  Krugman also borrows the idea of an ongoing negative real rate of interest, but this describes Battlestar Galactica, not the twentieth century.

Open market operations, when tried, seem to have worked in 1932.  Was Japan in a liquidity trap in the 1990s?  They could have printed more money and given it to me.  With an interpreter at my side, I would have spent it right away.  Who knows, maybe you could have helped me.  Here is a good critique of Krugman on Japan.

Perhaps there is a knife edge setting where printing too little money leads to hoarding and printing too much money leads to hyperinflation.  So a risk-averse central bank is stuck.  I doubt this, people don’t act so closely in accord but rather they adjust their cash balances at different speeds.  So again, just print some more money to get out of the liquidity trap.

What is the evidence for a liquidity trap?  Low nominal rates and the absence of a recovery?  That’s not much evidence.  I suspect real coordination problems are at fault in most of these settings, and hoarding is at most a secondary issue.  Few serious economic problems are purely monetary in nature, yet the liquidity trap encourages us to embrace that dangerous idea.

The bottom line: I once wrote a paper arguing the liquidity trap is possible.  Now I think that Milton Friedman was right all along.

1 Edgardo January 15, 2007 at 7:30 am

I agree 100% with your conclusion. I’d go further: although governments may aggravate economic problems by printing money to finance wars or to bail out banks o companies or any expenditure, these problems are not purely monetary in nature, except in the limited sense that if the government had not had the power to print monety, they could have been forced to reduce other expenditures o to increase taxes (an idea that the Argentina’s experience in the 1990s has shown to be wrong). Today it is hard to identify any economic problem that is purely monetary in nature.

2 Brad DeLong January 15, 2007 at 9:24 am

Anonymous has the key. The core idea is that the government swaps one liquid zero-interest-rate government asset–treasury bills–for another–cash. If banks wanted to expand their loans and needed reserves, cash would have an edge. If treasury bills carried a positive interest rate, they would have an edge. If neither is true, what’s the difference between the assets?

3 Alex Tabarrok January 15, 2007 at 11:21 am

Tyler is correct. More generally the focus in Keynesian macro on “the interest rate” and the market for loanable funds is overblown. The interest rate is an important price but there are many prices that equilibrate. The market for loanable funds is an important market but there are many markets that equilibrate.

Much of this comes from forgetting that GDP accounting is a convention. It’s important to remember, which no one ever does, that splitting Y up as Y=C+I+G is just one of a million ways that GDP can be split. Split Y in a different way and you get a different price and market as the primary equilibrating factors.

4 Patrick R. Sullivan January 15, 2007 at 2:02 pm

In Japan, in 1998, government bonds did get into negative nominal territory. In effect people paid the government storage fees to hold their money.

So, the zero bound may not hold, and Alex, Tyler, and Friedman are right. Anyway, they may not have had helicopters back then, but they could have paid bi-plane pilots to sprinkle $5 bills over cities.

5 Dave Iverson January 15, 2007 at 5:30 pm

Silly me.. Here a Krugman’s followup: FURTHUR NOTES ON JAPAN’S LIQUIDITY TRAP. Maybe this could provide a springboard to address my earlier request for clarification between a “credit crunch” and a “liquidity trap.”

6 Tony Apostolidis January 15, 2007 at 8:00 pm

Paul Krugman’s opinion on the liquidity trap doesn;t take into consideration the fact that every country is different in its monetary policy,which affects fiscal policy.So we have Greece and like other countries spend a huge percent of GDP in military investment,which creates holes for health,industry , private investment. With all these deficits , rates fall and the liquidity trap is just there.

p.s. of course i don;t argue on Brad DeLong’s opinion,because my friend,if banks want more money,they just create fictive money through loans and ensure cash overflow for many decades..i don’t consider hoarding,as money flows fast nowadays.

TAGLINE : If goverment or Central Bank prints out more money, the structural infirmities of most countries wont let Keynes ideas to be adapted in the real world and liquidity trap will appear.Try to stregthen public demand and private investment.
Tony Apostolidis , EUA

7 Bill Conerly January 16, 2007 at 12:20 pm

Japanese monetary policy was actually fairly tight in the 1990s. In the early 00s, though, they began “quantitative easing,” which meant increasing money growth despite having interest rates that were almost zero. That did the trick.

I’m persuaded that in some extreme cases, the monetary authority might have trouble implementing money supply increases through the banking system buying treasury bonds. But there are cases (Switzerland post WWII) of monetary policy being conducted using mortgages and other instruments.

Bottom line: if the central bank wants to get money into the hands of the public, it can. Once there, some portion of it will be spent. Hence, no liquidity trap.

8 Dave Iverson January 16, 2007 at 10:41 pm

While awaiting any help with my previous question as to distinctions between a liquidity trap and a credit crunch, let’s examine the last two sentences from TC’s post:

Few serious economic problems are purely monetary in nature, yet the liquidity trap encourages us to embrace that dangerous idea.

The bottom line: I once wrote a paper arguing the liquidity trap is possible. Now I think that Milton Friedman was right all along.

Let’s see, wasn’t it Friedman who said “inflation is always and everywhere a monetary phenomenon?” Can’t inflation be a serious economic problem? I think so. Of course most economists, including me, believe that monetary authorities can sustain “some” minor degree of inflation and that’s OK. Goldbugs disagree, of course.

Here is a snip from Krugman’s reply:

“What I pointed out in the previous note, however, is that there is a rarely noticed footnote to the conventional account of the neutrality of money: strictly speaking it applies only to permanent increases in the money supply. A monetary expansion that is perceived as temporary can, under some circumstances – namely when the market-clearing real interest rate is negative – be completely ineffectual at raising the price level, or (if prices are sticky) output. The point is that monetary policy isn’t really impotent; what makes it ineffective is that people don’t believe that it will be sustained. And conversely, a credible commitment to sustained monetary expansion will always be effective as an antidote to deflation.

Now you might say that structural problems created the situation in the first place; and you might be right. If you have a fix for the structural problems quickly at hand, fine. But if you don’t, monetary policy is still needed to fight deflation. And it doesn’t matter why the required real interest rate is negative; as long as it is, monetary policy will be effective if and only if the monetary authority is believed to be willing to allow long-term inflation.

Although still a believer in Liquidity traps and/or credit crunches, I have to disagree with Krugman when he says “[C]onversely, a credible commitment to sustained monetary expansion will always be effective as an antidote to deflation” I believe, that, in the wake of asset inflation then asset implosion, some things (think houses in bubble markets) can tank while other things (think “staples”) can require bundles of ever-inflated cash (think wheelbarrow loads if things really go to Hell).

Here is a Wiki link to monetarism that may shed some daylight on why there is sometimes reason to borrow ideas from the Austrians, the Keynesians, the neo-Keynesians or Post-Keynesians.

9 usa-battery October 25, 2008 at 4:14 am

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