Presumably in response to Scott Sumner, Paul Krugman writes:
And by that criterion, how much of the world is currently in a liquidity trap? Almost all advanced countries. The US, obviously; Japan, even more obviously; the eurozone, because the ECB probably couldn’t engage in Fed-style quantitative easing even if it wanted to, given the lack of a single backing government; Britain.
Krugman concludes that seventy percent of the world's gdp is in a liquidity trap. Krugman also defines a liquidity trap:
In my analysis, you’re in a liquidity trap when conventional open-market operations – purchases of short-term government debt by the central bank – have lost traction, because short-term rates are close to zero.
Krugman I am sure is aware that European short-term rates have not been always close to zero since the crisis started; as I read his post as a whole, he is simply noting that Europe refuses to use sufficiently expansive monetary policy. In essence "a shortfall in aggregate demand" is now defined as a liquidity trap.
But they're not the same thing, either definitionally, or more importantly in terms of their economic effects. In a true liquidity trap, money demand is a black hole which soaks up or shuts down all kinds of potentially expansive processes. Fundamental portfolio decisions stand at microeconomic "corners," as Keynes understood. Simply experiencing a "shortfall in aggregate demand" does not generate the same stultifying results. In the latter case there is still plenty of spending and investing on the "second round effects" of a policy change. For instance today investment is not shutting down as it would in a traditional liquidity trap; even gross investment should be drying up. It seems that investment (and intermediation) responds to plenty of incentives, positive and negative. There's simply not an infinite demand at the margin to hold non-interest-bearing assets.
A separate point is that overall aggregate demand can be too low, but some sectors, indeed many sectors, can be at margins which respond quite normally to supply-side incentives. Those sectors may rule the net comparative statics, even if we, at the same time, wish aggregate demand to be higher. A big tax on wages right now, for instance, would almost certainly do more harm than good, as would a big increase in the minimum wage. At the very least, both blades of the scissors matter, unless of course you think the demand curve for money is literally horizontal, which it does not seem to be.
In my view zero percent of the world is in a liquidity trap. Or you can redefine liquidity trap to mean "ongoing shortfall in aggregate demand," but then our new "liquidity trap" doesn't have the extreme counterintuitive properties which Keynes found so intriguing.
Liquidity traps seem a strange mythical beast to me, like the jabberwock (to use Krugman’s Carrollnomics mode of speaking).
I give Krugman no more than 36 hours before he either slits your throat or sets fire to GMU. None dare oppose The Laureate, whose powers are mighty and whose insatiable thirst for vengeance creates rivers of blood and tears.
“In my analysis, you’re in a liquidity trap when conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero.”
All this means is that Taylor-like rules that target the FFR break down. A McCallum-like rule should be able to work under this situation.
http://en.wikipedia.org/wiki/McCallum_rule
Krugman writes:
“In my analysis, you’re in a liquidity trap when conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero.”
You respond by saying:
“European short-term rates have not been always close to zero since the crisis started…In essence “a shortfall in aggregate demand” is now defined as a liquidity trap.”
But ECB rates *are* close to zero now. Even if the ECB were to raise them, it’s pretty clear that Krugman is arguing that a economy is in a liquidity trap if the Taylor rule would prescribe negative interest rates. I think Tyler is attacking a straw man.
Or am I the only one who doesn’t follow Tyler’s argument about aggregate demand?
“In my view zero percent of the world is in a liquidity trap.”
In your view, how much of the world was in a liquidity trap at some point during the crisis?
Tyler, the world economy faces two real problems.
1. The large change in relative prices of the past 8 years. Commodity prices have increased sharply and supplies have been responding too slowly. Almost everyhwere there is still too much uncertainty about the government policies (in particular environmental and energy policies) that have increased (sometimes sharply) the costs of producing commodities.
2. The threat of fiscal crises in several developed countries, including US, UK, France and Germany. Their governments have yet to signal that they are ready to take action.
Debates about aggregate demand and global imbalances are diversions from these two real problems.
Who is Pete Boettke?
Yeah people are overextended and de-leveraging.
liquidity trap is an interesting term. i think the US and other countries are in a liquidity trap, but not how classic economist would define it. think of what is happening in our economy: the fed has been increasing the money supply, banks are not lending, consumers are not spending and borrowing, and economic growth is no where to be found. Is that a liquidity trap? Money is not moving, despite a near zero fed funds rate.
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