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.

Comments

can someone give a one-paragraph or one-sentence definition of "liquidity trap" - i am not sure even though i have been reading along for a while that i properly understand the concept.

Could it just be that Kenyes was just horribly wrong and that government deficit spending doesn't stimulate the economy beyond a very very short term, but actually "de-stimulates" it beyond maybe a few months, which then requires more and more deficit spending to fix and leaves you in a sort of never ending hole until policy changes?

No Austrian would deny that there are many different loan rates of interest. When they talk of "the" loan rate, that is simply a heuristic device to organize their exposition, just as any econonmics teacher talks about "the" demand and supply of a good when drawing supply and demand diagrams on a board.
The theoretical question is: are the various loan rates too low compared with a natural rate, and does this lead to an excessive supply of credit with business cycle implications.

I take "liquidity trap" as an all-purpose term meaning "expansionary monetary policy doesn't work, for whatever reason."

Question: while we're arguing about the evidence for the efficacy of various forms of fiscal stimulus, what's the evidence that expansionary monetary policy ever works?

Anon. wrote:

No Austrian would deny that there are many different loan rates of interest.

I think Tyler meant, focusing on messed-up interest rates by itself is not a sufficient explanation for a boom. "So what if interest rate(s) are too low? Did the Wall Street quants not know how the Fed works? There has to be more to the story." etc.

What's wrong with the "real balance effect"? Seems to me that liquidation and the "real balance effect" is what restored the economy after all the depressions that came before the Great Depression.

I think there is a common sense argument for fiscal "stimulus" that its proponents often fail to make. It is generally acknowledged that since World War II the so-called automatic stabilizers have moderated the severity of recessions, presumably by making disposable income fall less than it otherwise would have, thereby sustaining consumer demand. In a "normal" recession, the automatic stabilizers and central bank monetary easing is enough; but now we're in the midst of a debt-deflation spiral of a kind unseen since the Great Depression, so maybe more is needed to cushion the fall. Frankly I dislike the term "stimulus", I think of it more as "stopping the bleeding", or, to carry the medical metaphor forward, stabilizing the patient to allow natural recovery processes (i.e. private sector investment) to take hold. As for the "liquidity trap" I suspect it's one of those economists' abstractions that obfuscates more than enlightens.

Dave beat me to my comment.

might that be "Robert E. Lucas" rather than "Robert H. Lucas"? or there's a Lucas I am not aware of?

If someone calls you pinheaded or ideological and doesn't address your arguments head-on, is it OK for you to call that person pinheaded/ideological/etc? If so, why haven't you?

Are some pinheads/ideologues/etc worthy of our attention no matter their level of pinheadedness/ideologueness/etc? If so, why?

oops...

"I also support the fiscal stimulus, as spending or tx cuts, as I DO support quantitative easing, helicopter Ben & etc..."

Opps, just saw that the a href HTML tagged-link for Masura Yoshitom''s concise, highly informative survey of Japanese monetary policy during the 1990s and down to 2004 didn't work.

It's such a good piece --- ending on an agnostic view that neither fiscal stimuli nor monetary policies (zero-interest rate, quantitative easing)did much to end the 12-13 year Japanese economic crisis --- that I'll try again: here.

....

Michael Gordon, AKA, the buggy professor

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