I've gotten a chance to read Jonathan's Mises Daily article on the liquidity trap, and I certainly don't regret recommending it in previous posts - it's very good. I jotted down thoughts as I was reading it, so I think the best way to present it in a blog post is just to go through the points the caught my eye, quoting him and then posting my response to him. It might be hard to follow this without reading the article, but I'm not sure how else to organize my essentailly bullet-point response.
JFC: “Broadly speaking, the economics profession is divided into two camps. One side is made up of "liquidationists" and "deficit hawks," supporting tight monetary policy and low — or no — government spending. The other group is composed of those fearing a fall in prices, who support easy credit and expansive fiscal policy to combat it.”
- I don’t think deflation is the primary concern – although it is an important one. Depressed output is the primary concern, and deflation is a concern because of the complicating factors it introduces to a depressed environment. The fact that this is not the major bone of contention is made clear by Hayek and Rothbard’s insistence that deflation is problematic, as well as recent expressions of the Austrian School’s allegedly close relationship to monetary disequilibrium theory.
- We need to appreciate how Jonathan goes on to delve deeply into the literature that provides context to this debate. For example, Krugman’s treatment of the Austrian school in 1998 isn’t strictly necessary for understanding his view of the liquidity trap. I’m not personally familiar with the details of this exchange, but Jonathan has done impressive due diligence by providing all these references here.
- On Krugman’s recent treatment of Hayek – I think the critique of Krugman has been overdone. I agree with Jonathan that Krugman doesn’t really seem to demonstrate an understanding of the macroeconomics of the capital structure (although he’s closer than many suspect – he does the sort of sub-sector analysis in his critiques that I’ve never seen an Austrian do thoroughly. I complain often on here about the lack of empirical verification of Austrian theory – Krugman’s blog comes closer to doing that than mises.org does). But he does correctly summarize what Hayek has said: that a “slow process of adapting the structure of production” is necessary. That sure sounds like we have to just wait and suffer through unemployment to me. Didn’t Mises call this purging the rot out of the system? I think we’re being disingenuous if we don’t accept that the Austrian school sees high unemployment as, to a certain extent, functional.
But later, Jonathan seems to agree with Krugman! He writes:
JFC: “This [the "Misesian-Hayekian" malinvestment framework] suggests — like Krugman accuses — that following a boom of malinvestment there will be a period of relatively high unemployment.”
If he really thought that, he shouldn’t have said that Krugman was “erroneous”.
Jonathan zeroes in on what I agree is the important point:
JFC: “As a general concept, the liquidity trap is legitimate in the sense that we are currently in a situation in which, despite the extreme provision of liquidity on the part of the Federal Reserve, there has not been a substantial increase in real private investment. As such, any Austrian rebuttal to Krugman should concede this point.
The real debate is whether or not fiscal stimulus can effectively revive an economy (or pull it out of a "liquidity trap") or if fiscal stimulus contributes to the existence of a liquidity trap — there is the distinct possibility that this so-called liquidity trap is the product of regime uncertainty, which may or may not be aggravated by government policy.”
- And it’s about more than just that. Does monetary policy work? The original purpose of highlighting the liquidity trap was to demonstrate a circumstance under which it wouldn’t. But is that really the case? A lot of people don’t think that is the case. I’m not sure what I think, but I’ve been content to say that “monetary policy is less effective in a liquidity trap than it would otherwise be”
- When he describes the liquidity trap here, he’s really describing the symptoms rather than the underlying cause. That’s fair enough, but it would have been nice to explain exactly what a liquidity trap is near the beginning: it is a situation where cash and bonds become interchangeable. How that is depicted in a model has been debated, but that’s the fundamental point.
JFC: “Keynes believed that such a situation occurs out of a change in the "state of expectation." In other words, an increase in uncertainty leads to an increase in the demand to hold money and a decrease in investment, based on the belief that money's relatively riskless qualities makes it more desirable to hold than bonds and assets”
- Yes, there’s that – but presumably the risk premium can be compensated for. The point is, at low interest rates there is no longer any compensation for the risk. So I think the key here is the interest rate, not the relative risk.
JFC: “Given a "virtually absolute" liquidity preference, monetary policy becomes ineffective at stimulating "aggregate demand" since an increase in the supply of money cannot increase wage-earners' incomes.”
- Does monetary policy stimulate aggregate demand by increasing wage-earners’ incomes or by lowering the interest rate? I always thought it was lowering the interest rate.
JFC: "Between 1940 and 1970, the liquidity-trap theory went through major changes and reformulations, only for Hicks to recant, suggesting that, "[w]hile one can understand that large balances may be held idle for considerable periods, for a speculative motive, it is harder to grant that they can be so held indefinitely.""
- I’ve always been suspicious of this “recantation” by Hicks. Whoever said they would be held indefinitely? I know Hicks’s change of heart was broader than this and perhaps there was more to it than this, but this particular quote never struck me as particularly convincing. He seems to be recanting a strawman, in other words. I don't see the later Hicks making a convincing argumetn against the earlier Hicks, in other words.
JFC: “Where Krugman parts ways with Keynesian precedents is in applying a theory of intertemporal expectations, where monetary policy is ineffective because of the expectation of future deflation — the public believes monetary policy to be only temporary, as opposed to sustained.”
- This is actually probably better put as “Krugman parts ways with Hicksian precedent”. Keynes actually uses these expectations arguments quite frequently in the General Theory. Hicks put it into a static model, so a lot of the original Keynesian discussions of expectations were forgotten. I don’t mean to be argumentative with Jonathan on this point – I actually mean to deflate Krugman’s originality a little bit and give more credit to Keynes (who may not deserve original credit himself, in all likelihood).
JFC: “While Keynes and Hicks would have perhaps shied away from massive monetary stimulus, operating with the understanding that monetary policy was ineffective during a liquidity trap, New Keynesian theory puts much more importance on a growing money supply.”
- This is what I’ve always thought as well, and that’s the impression I get from the General Theory, but what’s interesting is that Keynes does express a very similar monetary prescription in an open letter he wrote to Roosevelt – I believe in 1938. He said two things were needed: fiscal stimulus, and the reduction of long-term interest rates. Presumably one would reduce long-term interest rates with the sort of quantitative easing policies being proposed today.
JFC: “Austrians instead see the resulting fall in the price level as the cure for deflation (or fall in the money supply). Recognizing the problem as the result of a fall in profit, due to the deceleration of credit expansion, the problem of demand necessarily stems from the inability to pay for products demanded. The solution is a fall in prices of relevant goods and services, to the point where demand for them can once again rise. In other words, conceding that a fall in the money supply will lead to a decline in spending, the only method by which spending can rise is through a fall in the price level.”
- I could see why a falling price level as a "solution" would result in re-equilibration. I don’t see how it addresses the fundamental dynamics of the deflationary spiral. The whole point of the deflationary spiral is that deflation further constricts the money supply, which causes more deflation. At some point, one may think that a real balances effect would put a brake on this. I am more persuaded by the idea that at some point the need to replace capital will put a brake on this. Either way – simply letting prices fall alone doesn’t seem to provide a solution to a problem that is caused by falling prices, unless you reject the logic of a deflationary spiral in the first place (which Jonathan doesn’t seem to).
JFC: “The alternative method, or the Keynesian "solution" of inflation, can lead to a temporary "recovery." Nonetheless, such a policy would inevitably result in greater malinvestment and a greater net loss of wealth.”
- This is probably an instance where it would have been better to distinguish between Keynes and Krugman explicitly. Not that inflation didn’t play an important role for Keynes, but it plays a much more important role for Krugman. However, I think even for Krugman this is only the monetary half of the story.
JFC: “However, rising uncertainty and low expectations for the future, brought about by economic depression, can be considered legitimate factors behind a liquidity trap. In this case, we define a liquidity trap as a situation in which private investment stagnates despite the readjustment of the structure of production. One such situation of this occurring was during the Great Depression. This topic is tackled by Robert Higgs, in which he attaches the blame to "regime uncertainty," or uncertainty caused by a general antibusiness climate produced by the government.”
- The policy uncertainty argument always seems odd to me. Empirical evidence suggests that the policy uncertainty is of minimal concern to businesses relative to other uncertainties (i.e. – demand uncertainty). The arguments of Higgs and others always strike me as a case of post hoc ergo propter hoc. The policy reacts to the business climate, not vice versa. This at least seems to be what we see in the business confidence data.
JFC: “Wealth-producing investment relies on two underlying factors: that there exists a demand for the product and that the producer can satisfy that demand at a profit or by receiving greater satisfaction in return. That government cannot satisfy another's demand at a profit can be extrapolated empirically, because if it could, there would be no need for deficit spending — the capital necessary to fund these programs would come from received profits.”
- I think this whole statement is problematic. I could probably agree with the first part of the definition – that there exists a demand for the product. I don’t see what profits have to do with it. What about a competitive situation where economic profits are driven to zero? What about non-profit institutions – do they not produce wealth? Profit seems to me to be important because it provides an incentive and information on consumer demand. It doesn’t seem to me to be definitionaly essential to wealth. I’m also having a hard time understanding what deficit spending has to do with it. Firms finance projects in a variety of ways – why should the government be any different? The share of government financing coming from debt can easily be explained by the unique qualities of the government – its status as a sovereign guarantor of currency, its longevity, etc. I really would have preferred that Jonathan defend this understanding of wealth more sufficiently.
JFC: “Fulfillment of satisfaction is dependent on individual subjective evaluations and voluntary exchange. Government, instead, distributes capital towards otherwise unwanted ends, taking it away from the private sector and "producing" at a net loss.”
- This seems to assume complete property rights. Otherwise, how else could Jonathan conclude that capital is moved to “unwanted” ends. Whether the ends that government moves capital towards are “unwanted” or not is indeterminate unless you are assuming complete property rights. Therefore, I’m forced to conclude that Jonathan is assuming complete property rights. It’s a bad assumption.
JFC: “The difference between Hayek and Krugman is that Hayek was not a utopian, and realized that economic growth can only once again take place if the structure of production adapts to society's time preference — there is no formula by which government can centrally plan wealth creation.”
- The non-utopianism is a quality of Hayek, but I don’t see how it is a point of difference between Hayek and Krugman. Hayek and Krugman are simply different kinds of non-utopian. Krugman certainly doesn’t believe there is a formula by which government can centrally plan wealth. They both think that there is a course which is closer to an ideal than an alternative course. If that belief alone is utopian, then they are both equally utopian – but I don’t think that simple belief is enough to qualify someone as a “utopian”.
I think one of the biggest liabilities of this piece is that it goes from a reasonably relevant Krugman v. Hayek discussion, to the liquidity trap, and then on to questions of deflation in general, ABCT, etc. I think the transition from the liquidity trap to deflation was perhaps appropriate given the important of inflation and deflation to Krugman's version of the liquidity trap, but I think it gets a little farther afield when it gets into the deflationary spiral - which it seems to me is quite different from the liquidity trap.
Part of the problem is that the liquidity trap is hard to incorporate into a theory like the Austrian School's, which for the most part doesn't incorporate anything like liquidity preference. Hayek's "loose joint" of money was the passage of time. For Keynes, the loose joint was more than that, and it came from liquidity preference (Garrison calls it a "broken joint" for Keynes - I think "looser joint" is probably more accurate). Without a well incorporated concept of liquidity preference, it's hard for Austrians to engage the liquidity trap. Policy uncertainty is invoked to explain what we see empirically and the concern with low rates and the capital structure is invoked to address the theoretical symptoms of the liquidity trap. But the real heart of it - the indifference between cash and bonds - is left completely untouched.