Wednesday, June 2, 2010

The Liquidity Trap - A Self-Taught Tutorial

In the comment section of a post from yesterday, Jonathan asks:

"I'm not sure, but in The General Theory Keynes doesn't refer to the liquidity trap in the sense of reaching a lower bound on interest rates. At least, I haven't come across it (maybe he does). I thought that this particular concept was developed in the 1950s, or at least after The General Theory?"
As I suggested, the liquidity trap plays a very minor role in the General Theory, although it is there. In his chapter on liquidity preference, Keynes writes:
"There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this even the monetary authority would have lost all effective control over the rate of interest. But whilst this limiting case might become practically important in the future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest."
My feeling is that J.R. Hicks's version of the liquidity trap as a horizontal portion of the money demand (and LM) curve at some positive interest rate is the most faithful representation of what Keynes was trying to say. At the same time, you can see where modern "zero lower bound" versions of the liquidity trap, like Krugman's, come from. In the 1990s, Krugman promoted the "zero lower bound" version of the liquidity trap because at that point everyone had forgotten about the concept (most of the time between Keynes and Krugman was dominated by higher interest rates). Krugman was reviving it to explain what was going on in Japan. Anyway, if you sanitize Keynesianism of all the concern with uncertainty about the future and liquidity preference, then the zero lower bound version makes perfect sense, because that's the point where cash and bonds become perfect substitutes. The only reason why the liquidity trap would take hold prior to a zero interest rate is if you have some sort of "uncertainty premium" or "liquidity premium" that you build in, which is essentially what Keynes did. I would argue that Keynesiansim never should have been so thoroughly cleansed of liquidity preference.

I also think it's important to think of the liquidity trap as more of a spectrum, or a gradually closing trap. Even if demand for money isn't perfectly elastic, if it becomes relatively elastic it makes monetary policy relatively less efficacious (note - in yesterday's post I said that money demand was "inelastic", when of course I meant "elastic" - that is now updated). Why not use fiscal policy to shift the IS curve until it reaches a point where monetary policy is more useful? When Scott Sumner scoffs at the prospect of a liquidity trap, responding "well why don't you print more money", my reaction is "why would you want to create monetary inflation - which gets harder and harder to do as you go along - when a much more effective and less distortionary option is available". I'm not terrified of inflation, but the Sumner position seems nonsensical to me, at least at a time like this. The general principle is that monetary policy becomes less useful at lower interest rates, not because of a zero lower bound (although that's a practical obstacle to a certain extent), but because of liquidity preference. Fiscal policy becomes less useful at higher interest rates where monetary policy can do the job without adding to the public debt or risking distortionary intervention. This is my view, although I'll caution that a lot of it is self-taught (and not under the tutelage of bloggers - while I respect Paul Krugman and Scott Sumner, you'll notice that this is one area where I depart from both of them).

The New School for Social Research has a good page on the practical challenges to the liquidity trap here. This is what is known as the "real balances debate". Basically, deflation causes real balances to go up which combats liquidity preference. So the "liquidity trap" is self-correcting. At some point, I know Krugman actually worked out the real balance effect and demonstrated that it is minor. People don't get windfalls on assets from deflation. While there is some real balance effect, it isn't enough to correct the liquidity trap. I'm both writing that from memory and trusting his math on it, of course. Generally speaking I think the real balance effect is real, but probably minor. We just don't have the deflationary swings that we used to. And of course even if you get out of a liquidity trap, it doesn't mean demand isn't still depressed. You don't need a liquidity trap for depressionary conditions in a Keynesian model - the liquidity trap just ties one hand behind your back while you're fighting that depression!

UPDATE: Xenophon shares this critique of the liquidity trap. That reminded me I had two pieces of literature I wanted to share. This is a critique by Scott Sumner in the Cato Journal (I haven't read this in its entirety yet), and this is a good review of the history of the idea in History of Political Economy (I have read this), and this is Krugman's paper on the liquidity trap and Japan.


  1. You know you've been thinking about this stuff for too long when you glance at a newspaper headline with the word "Islam" in it, and you read "IS-LM".

  2. What I have recently read on the "trap."

  3. Of course I forgot the link:

  4. Thanks Xenophon - I updated with your link

  5. Although I kinda disagree with it all, this is my understanding of the argument for fiscal stimulus:

    The paradox of thrift is the primary justification for government to engage in monetary. Capricious and rapid declines in total spending are responsible for periodic recessions. Although prices ordinarily coordinate economic activity toward productive ends, the normal equilibrating properties of markets cease to function. A non-market institution must intervene and combat recession by stimulating total spending. Only government is capable of satisfying this role, and so it must be empowered to pursue monetary policy.

    What is true for a part of an economy may not be true for an economy as a whole. Although an individual can increase his savings by reducing spending relative to income, spending and income must be equal for the economy as a whole. One person's spending is another person's income, and vice versa. Thus, any change in total spending must correspond to an equal change in total income. Unlike an individual, it is impossible for the economy as a whole to decrease spending relative to income at the same time.

    If an economy as a whole attempts to increase savings by reducing spending, both spending and income fall and the paradox of thrift follows. As total income declines, profits shrink or disappear, inventories accumulate unsold goods, and businesses begin laying off workers. A surplus of goods and labour develops, because there is not enough spending to buy all that is produced. The expanded savings merely result in the unemployment of resources, stifling economic growth and adding to human suffering. The notion of saving for a better future is turned on its head. The seemingly rational response of tightening one's belt during hard times actually exacerbates the problem by further reducing total spending.

    As long as one person's reduced spending is offset by another persons's increased spending, there is no problem. However, any attempt to decrease spending relative to income is futile for the economy as a whole, and it actually impoverishes the future by creating recession in the present.

    Basic economics informs us that a surplus of goods reduces prices, and so the price of goods and labour must fall until total spending is again able to purchase available resources. However, prices in a real economy may respond slowly and unevenly, e.g. the unemployed may be unwilling to accept lower wages, producers may hold out for the economy to recover, contractual obligations may enforce old prices, and unions may delay wage cuts to name but a few difficulties. Although a new general level of prices will assert itself in the long run, the interim will likely be fraught with economic distress and political upheaval.

    Furthermore, a recession is unlikely to be accompanied by a long term change in spending habits; the attempt to reduce spending is usually just a temporary swing brought about by panic. Businesses will fail and people will lose their jobs, and then, when the economy recovers, those businesses will need to be rebuilt and those people rehired. Such a recession does not bring about any lasting structural change to the economy, but merely sees it torn down and reconstructed for no economic gain. Prices may equilibrate supply and demand instantly in basic economic models, but prices in the real economy cannot respond accurately and timely to extreme swings in total spending ... [Continued below]

  6. The disastrous economic consequences of the paradox can be mitigated by apt government intervention; astute monetary policy can lessen or prevent falls in total spending. All money is owned by someone, and so the supply of money must be equal to the total quantity of money that people own. An attempt to expand total cash balances is an attempt to increase the total quantity of money that people own, but this is impossible without an expansion of the money supply. A government can stimulate total spending by expanding the supply of money, because additional money will be spent once the higher quantity of money demanded has been satisfied.

    The liquidity trap is the primary justification for the government to engage in fiscal stimuli. Although a monetary stimulus the best way to resolve an excess demand for money, it is limited to by the downward pressure it puts on interest rates.

    The government can help to offset a fall in total spending by temporarily increasing its own debt-financed spending. If total spending has fallen because of uncertainty, then money must be considered a relatively safe asset. The government can increase the supply of an alternative safe asset by issuing bonds. Savers who are unwilling to part with their money for anything else may be persuaded to purchase government bonds. The borrowed money can then be immediately spent on public goods to stimulate total spending.

    Fiscal stimuli are ordinarily inferior to monetary stimuli. However, if central bank purchases of bonds drive interest rates near to zero, then the excess demand for money is greater than it is possible to offset with monetary policy. When interest rates are near to zero, money and bonds become near perfect substitutes. Fiscal stimuli then emerges as a the next best tool to combat deflation.

    Is that right?

  7. I emphatically suggest you read Henry Hazlitt's critique of Keynes' notion of "liquidity preference" if not the entire work of The Failure of the New Economics.

    I understand you're not familiar with Hazlitt, so I should caution you that he has nothing encouraging to say about Keynes. He refutes every central pillar from the GT but I can't say to what extent to modern Keynesianism departs from what he rebuts. At any rate, knowing where a theory falls apart is always helpful when constructing adequate models of the real world.

    I suggest you take a look:

    Particularly chapter XIV "Liquidity Preference" page 186.

  8. Lee Kelly -
    I think that's a great description, but I have three points of clarification, at least IMO:

    1. First, I actually have major problems with this: "Although prices ordinarily coordinate economic activity toward productive ends, the normal equilibrating properties of markets cease to function. A non-market institution must intervene and combat recession by stimulating total spending." I don't think anyone is saying that markets cease to function or that prices don't do what they've always done. Keynesians don't challenge the efficient coordination of markets so much as they challenge the idea that markets will always settle at a full employment level. Of course there are specific market failures that people point to in specific cases, but there is no underlying assumption that "the normal equilibrating processes cease to function".

    2. I think the adjustment time and the general sense of "sticky prices" is important in practice, but I just want to stress that it's not necessary at all for a downturn caused by depressed demand. You can have smoothly adjusting prices and still have the same depressionary results. Of course slow adjustment is real and adds further friction to the system, but I just want to note that (IMO at least) it's not as central as some people make it out to be.

    3. Perhaps this is what you meant, but I want to clarify that I don't think there's any reason why there has to be a liquidity trap for fiscal policy to be useful. Fiscal policy becomes even more of an imperative in a liquidity trap because monetary policy becomes relatively (if not completely) useless - but it can be useful outside of those conditions. I don't think fiscal policy can be expected to be useful in downturns that are not characterized by depressed demand.

  9. Mattheus -
    Since you provide a targeted citation, I will take a look. I don't want to appear closed-minded when I rebuff some of your reading suggestions. I basically operate on the assumption that Hazlitt provides the foundation for a lot of the critiques of Keynes that I read. Is there anything fundamentally different between what he says on liquidity traps and what someone like Frank Shostak regularly says on I'm guessing there's not much difference, and for that reason I never really feel like taking up time with books like that. I don't have a lot of time to just sit and read, so I want to choose the books that "challenge my thinking" carefully. I'm more interested in what Austrians have to say about capital structure and credit cycles than what they have to say about Keynes or praxeology (although I find praxeology intriguing). I've never been that impressed with Austrian critiques of Keynes that regularly cite Hazlitt (the Mises crowd). I've been more impressed with some others (the NYU crowd, one or two people at Mason) - so that's going to color what I take the time to read. I'm guessing it's indicative of the quality of Hazlitt's work.

  10. Think of it this way - if you felt the need to direct some attention to Keynesian economics, would you read something called "Ten Reasons why the Austrian School is Wrong", or would you read The General Theory?

  11. Also - if I remember correctly from earlier conversations, you haven't read the General Theory - correct?

    How in the world are you competent to declare whether Hazlitt's critique is a valid one if you haven't read the General Theory?

  12. OK, I've read it -

    1. Hazlitt really over analyzes the phrase "reward for parting with liquidity". Is Hazlitt's "the market is not a Sunday School" comment really necessary or insightful? Does he really think Keynes has a different understanding of the price mechanism than he does? He's not even attempting to read the "reward for parting with liquidity" phrase in the context of the wider field of economics.

    2. His point on the tomatoes is confusing. What problem does he see with the fact that when you trade cash for tomatoes one of the things you're trading away is a liquid form of money. When demand for tomatoes increases your money demand increases because you need the liquid cash to pay for them. That's why the LM curve slopes up after all! He's acting like the idea that you're trading tomatoes for liquidity is ridiculous, but what's so ridiculous about it? When you conduct more transactions you trade away liquidity. Like ANY two goods, as you buy more of one the rate of substitution between the two changes. What exactly is objectionable about that?

    3. I will agree with Hazlitt's next point, that to a certain degree liquidity preference and time preference are similar ideas. But I don't think that makes liquidity preference useless. First, Keynes and Keynesians don't jettison time preference - let's get that on the table. But liquidity preference is more than just temporal discounting. Liquidity preference is the preference for the ready availability of money to deal with unforseen circumstances. Time preference is simply saying "I prefer a good now 1+r times as much as I prefer the same good in the future". But they are related. Your demand for liquidity is going to be informed by your time preference. If you're concerned about having liquidity in the medium term your liquidity preference is going to be lower than if you're concerned about having liquidity in the near term.

  13. 4. It seems to me his discussion of selling the house has absolutely nothing to do with what Keynes is thinking of when it comes to liquidity preference.

    5. Hazlitt I think overstates Keynes's concern about speculation and turns him into a moralizer that he really wasn't. That having been said, I've never been especially attracted to the concerns with speculation that Keynes does raise.

    6. At the top of page 192 Hazlitt seems to forget that demand curves slope down... not a good sign from an economist at all. The interest rate is the opportunity cost of holding money. When the interest rate is high you want to hold less money. When the interest rate is low, you want to hold more money. The interest rate has to increase for people to hold less money. I'm not sure exactly what Hazlitt is confused about here. I think he's thinking of interest as the price of liquidity rather than the opportunity cost of liquidity.

    OK - that's where I left off - the end of 192. And I have to say that last page wasn't very encouraging. I may come back to this or I may not... right now I've got a blog post of my own to write.

  14. I've read various chapters from the General Theory (I really need to sit down with the entire book) from this and that lesson I am learning, but as a composite whole I have not read it. The dozen chapters or so I've read have also been supplemented by Hazlitt's insights on Keynes' meaning.

    Again - I never said Hazlitt was the end all, be all of economists nor did I say he got everything right. It just seems to be a relevant insight into what is Keynes' predominant theory of interest.

    In the following chapter, it is explained that Keynes takes a purely monetary explanation of interest (like Hicks) and discounts or at least only implicitly accepts real factors that change the rate of interest.

    I think what is true is that everything Keynes got right on interest has already been discovered decades previously. His liquidity preference theory was virtually pre-capitalistic and when he begins to explain theories of interest as "the reward for parting with liquidity," I think Hazlitt sufficiently takes him to task.

  15. Daniel, I suggest this (much shorter than Hazzlit's) critique of Keynes by George Reisman

  16. And this one connects Reisman's critique to the issue of liquidity trap

  17. Daniil - I'll do my best to get to these, but it is going to be a busy week and weekend for me.

    I am going to try to respond to the comment you left about Keynesianism in general on the other post.


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