Another way to think of the liquidity trap

The liquidity trap is often cited as the reason why fiscal policy is required to get us out of the downturn. 

My view is this: the short-run nominal interest rate is different than is
socially optimal but that doesn't mean the economy is in a trap.  Liquidity trap proponents have lots of good evidence for the former proposition but much less evidence for the latter notion of a true trap.

I think of liquidity trap arguments as stressing the extreme importance of a single market price, namely the relative price between cash and T-Bills.  In general I am suspicious of macroeconomic arguments which place so much weight on a single price being out of whack.  You can put the Austrians into this camp (the loan rate of interest is wrong) and you can put the supply-siders into this camp (the tax rates on labor or perhaps capital are too high).  Even though I think the short-run interest rate is "wrong," from the point of view of social optimality, that is not a driving fact of central macroeconomic importance.  This doesn't have to be a "pro market" argument: in fact one can think that many different prices and quantities have comparably important degrees of "wrongness."

Here's a short list of economists who have expressed (varying degrees of) skepticism about liquidity trap arguments: D.H. Robertson, Jacob Viner, Milton Friedman, Philip Cagan, Don Patinkin, Auerbach and Obstfeld, Robert H. Lucas, Greg Mankiw, and, I might add, Bernanke and Blinder.  You can make a case for adding Franco Modigliani to the list, although his article is cryptic in some regards.  Leo Svensson has many interesting papers critical of the idea of a liquidity trap as a binding constraint. 

It is possible that of these people are wrong but they do all understand Keynes's theory of interest and they do all understand how the liquidity trap is supposed to work.  Nor are they merely citing "the real balance effect" as it is usually dismissed.  These economists just don't think that so much in an economy can revolve around a single incorrect price.  Many or all of them believe that monetary policy can work on other prices as well and through other channels.

There is also some good evidence that maybe the Great Depression wasn't a liquidity trap either.  Here is some evidence against Japan having been in a liquidity trap in the 1990s.  Neither of those papers is definitive; my point is that people who are skeptical of the liquidity trap argument aren't simply being pigheaded or ideological.

The overall point is that this talk of a liquidity trap — as a true trap (and not just another screwy price) — is a speculative hypothesis, not an obvious truth.

And unless you regard "the liquidity trap" as a true trap, you needn't favor such a large fiscal stimulus.


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