Why I assign less weight to the liquidity trap argument

by on November 1, 2010 at 7:47 am in Economics | Permalink

A few people have been asking me about this, so here is a summary statement of some points:

1. The liquidity trap argument implies that the money-short bonds margin doesn't, at current magnitudes, matter.  I am more closely wedded to marginalism than that.  The argument also sees all the action (or should I say, non-action) in one margin, the money-bonds margin.  The money-goods margin matters too.  In the liquidity trap argument, everything is decided by one irrelevance result at a single margin in a highly complex multi-trillion dollar economy.

2. Short-term interest rates being zero, and short-term interest rates being almost zero, are very different cases, especially for understanding nominal shocks and whether they can stimulate aggregate demand.  Unless short-term rates are literally the same as the rate on cash, asset swaps still can succeed.  And QEII isn't be the same as simply switching the term maturity of the debt, as Krugman has suggested.  There will be nominal effects also.

3. Even Keynes didn't believe he had ever seen a liquidity trap, including in the Great Depression.

4. Most of the good predictions of the liquidity trap models are covered by recognizing there are lots of unemployed resources and weak business confidence.  

5. Consumer spending just rose 2.6 percent and business profits are high, yet we are in a liquidity trap?  What exactly is the story here?  "We can get spending up by 2.6 percent but not a smidgen higher"? 

6. The stock market responded positively to the announcement of QEII and the TIPS spread went negative; both are the opposite of what a liquidity trap model would predict.  Markets don't seem to think the liquidity trap idea is a very useful one and that alone creates real positive effects from monetary policy.  If markets don't believe in a liquidity trap, that's enough for the trap not to bind.

7. Monetary policy worked quite well in the Great Depression, when it was tried.  And on Japan I am persuaded by Scott Sumner.

These points are a less fundamental, but they are still relevant to the debate, if not always to the substantive issue itself:

7. There are different liquidity trap models.  For instance I often see the "short nominal rates are zero" model being confused with the more stringent "money demand is a bottomless sink" model.  It's only the latter case — clearly not true today — which generates the extreme results of liquidity trap models.  Otherwise the money-goods margin remains operative and monetary policy can succeed.

8. Some of the LT models imply upward-sloping AD curves and downward-sloping AS curves, yet I don't see anyone applying those assumptions consistently to other decisions, such as tax policy for instance.

9. If a liquidity trap is to persist beyond the short run, something must be preventing the marginal product of capital from adjusting upwards and solving the problem.  In other words, a non-short-run version of the liquidity trap has to be combined with an account of problems on the real side.

10. I see liquidity trap proponents spending a lot of time criticizing naive versions of real business cycle theory, bond market vigilante arguments, and so on.  They spend less time engaging the most serious criticisms of the liquidity trap argument.  A study of the liquidity trap literature does not raise one's confidence in the idea, though it might sound OK if the relevant alternative seems sufficiently bad.

11. Whether or not we should use fiscal policy depends on how well our government can target and mobilize unemployed resources; you don't need a liquidity trap to address that argument.

12. Ultimately I view the liquidity trap idea as a kind of shaggy dog that's been pulled out of the closet.  If it's going to be made convincing, it needs a lot more work than simply repeating that some short-term interest rates are near zero.

Andrew November 1, 2010 at 4:13 am

It just seems a bit arrogant to always expect to be able to manipulate people and when it doesn't work that's a problem to be fixed by some other finagling.

So, more money doesn't create an instantaneous boost in output. Well, what if it's not linear. Maybe there is a cutoff point and we throw up our hands right before the banks get to zero and then positive on their balance sheets? Maybe that's just a primitive way of restating the point on marginalism. I'm not saying we should rescue banks. We need them like a hole in the head. That's a historical fact at this point. But if you people have decided to rescue banks, then keeping them on minimal life support may be the exactly wrong strategy.

Luis Enrique November 1, 2010 at 4:43 am

OK, whether or not we should use fiscal policy depends on how well our government can target and mobilize unemployed resources. And how hard is hiring unemployed workers right now? Of course government hiring will involve some reallocation of workers, as opposed to pure employment of the current unemployed, but should anybody really be thinking "well, I'm against fiscal policy because I don't believe the government knows how to "target" the unemployed".

Is this worry anywhere near to binding, so to speak, whilst unemployment is so high? Especially as things stand fiscal policy isn't so much about trying to hire the unemployed but more about not firing the currently employed, via budget reductions.

Kevin, you seem to like this argument against fiscal policy and to be worried about the governments ability to target the unemployed. So, take some hypothetical government job creation program – say infrastructure maintenance – for every 100 workers recruited, how many would you guess would come from the ranks of the currently unemployed?

Bill November 1, 2010 at 5:16 am

Great. if we aren't in a liquidity trap, then QE will solve everything.

Floccina November 1, 2010 at 7:14 am

"Whether or not we should use fiscal policy depends on how well our government can target and mobilize unemployed resources; you don't need a liquidity trap to address that argument."

You know I wonder if they could by offering very low pay and benefits for some set of new jobs.

Nick Campbell November 1, 2010 at 7:37 am

Okay so something I don't understand about all of this is the why we are pursuing QEII when QEI had such limited results. It seems to me that if the savings rate increases after QEI and consumption isn't growing at the rate expected that maybe we should go the other route and try to stimulate investment and improve unemployment through it so that consumption can improve as a byproduct, but no one seems to pursue that idea so I assume my idea is very very basic or missing some pieces of information. Could someone please explain to me what I'm missing?

Bill November 1, 2010 at 9:32 am

Re point #11: Why would you use fiscal policy if the MPC equals zero, as we learned last week?

rayward November 1, 2010 at 1:31 pm

The libertarian way (which for this purpose is the same as the neo-classical way), the Cowan way, will, in the long run, solve the low output, high unemployment problem. That's okay by me, as long as the "long run" isn't too long. At my age, "too long" isn't very long. On the other hand, Cowan knows (at least I hope he knows) that his comment, "[w]hether or not we should use fiscal policy depends on how well our government can target and mobilize unemployed resources", is irrelevant to Keynesian theory, and makes me question whether it's the Keynesian theory with which Cowan has a problem, or government spending to achieve some idealized outcome.

schtevie November 2, 2010 at 7:09 am

Why you assign less weight to the liquidity trap argument and why Bob Barro cannot, despite his honest, best efforts, find a fiscal multiplier that matters in a depression are of the same piece. Some ideas and facts simply aren't congenial with one's ideology and intellectual edifices.

Point 11's "Whether or not.." and Point 12's "..it needs more work..", now that's some funny stuff.

Owen Dolan November 3, 2010 at 10:32 am

"Whether or not we should use fiscal policy depends on how well our government can target and mobilize unemployed resources; you don't need a liquidity trap to address that argument."

I agree with this statement, but wouldn't your view on the liquidity trap influence what fiscal policies to pursue, i.e. tax cuts or increased spending? I'm not that bright, but if someone decides that QE isn't going to increase consumption, how could they advocate for tax breaks over government spending?

J Thomas November 4, 2010 at 3:48 am

Tyler, you point out that the "liquidity trap" idea is too simple, and cannot work as stated.

Is there something kind of like a "liquidity trap" which can play an important role in an economy? Something which this particular shaggy dog story does not describe well, but which could be described well?

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