Nobody Needs to Understand the Liquidity Trap

Warning – This post is extremely nerdy and could result in extreme sleepiness.  Do not try to read this post while operating heavy machinery.  

Paul Krugman says I don’t understand the liquidity trap.  Which is weird because I’ve been saying he doesn’t understand the way Keynes originally used the liquidity trap. You see, Keynes described a liquidity trap as an environment in which short-term debt and cash become near equivalents resulting in the Central Bank’s loss of control over interest rates and their ability to stimulate the economy.  The Fed clearly hasn’t lost control of interest rates and I tried to use the TED spread to express this point, but Dr. Krugman isn’t using the same definition of a liquidity trap as Keynes did so it’s not surprising that there’s some confusion here.  So here’s how Dr. Krugman describes a liquidity trap:

“Look, the liquidity trap — which is basically the same as saying that even a zero short-term interest rate isn’t low enough to produce full employment — is a situation in which increasing the monetary base has no effect on aggregate demand, because you’re substituting one zero (or very low) interest asset — monetary base — for another zero or low interest rate asset, short-term government debt. Conventional monetary policy is completely sterile on all fronts.”

That’s pretty simple.  Dr. Krugman is actually saying that the price of money is too high because interest rates are at 0% and there’s still an output short-fall.  But I don’t think the Krugman Liquidity Trap is the reason why the Fed can’t get us out of this mess.  In fact, I don’t think the Fed has the tools at present to get us out of this mess.

So, this is awkward.  How is it that we both agree that there is a short-fall in aggregate demand, agree that conventional monetary policy has become ineffective, both predicted low interest rates and low inflation, both said Bill Gross would be wrong in 2011, both agree that fiscal policy would be effective in solving the problem and yet we disagree on how we come to those conclusions?   I think it’s pretty simple also.

Here’s the thing.  Dr. Krugman is using a framework of the economy that is Wicksellian to a large degree.  That is, what Dr. Krugman is really saying, when he speaks of the Liquidity Trap, is that “the price is wrong”.  This is the idea, originating with Knut Wicksell, that there is some interest rate at which output equals potential.  Since interest rates are at 0% and the economy is still operating well below potential then Dr. Krugman concludes that we’re in a liquidity trap where “the price” of money is too high.  And if we could just reduce the price of money then we’d be able to get to our full potential output.  So he advocates increasing inflation expectations to reduce real interest rates or implementing fiscal stimulus if that doesn’t suffice.

So what the heck am I fussing about with all that?  Well, I agree with JM Keynes again.  Not only are we not in a liquidity trap according to a true Keynesian definition, but all of Krugman’s talk about a “natural rate of interest” is not very useful.  Here’s what Keynes said about the idea of a Wicksellian “natural rate” in the General Theory:

“I am now no longer of the opinion that [Wicksell’s] concept of a ‘natural’ rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.”

This idea of a “natural rate” is largely theoretical.  No one actually knows it if exists anywhere other than in simplified textbook descriptions of the economy.  It certainly exists in a barter economy with real exchange of goods and services, but there is no empirical evidence that it exists in a monetary economy in any manner that would help us in steering policy.  And more problematic is the fact that there are actually many, many different natural rates so who could possibly know if there is ever an environment in which all of these natural rates will clear creating an aggregate environment of “full potential”. And I am certainly skeptical of such a view and the conclusion that the Central Bank has the tools to get us to this “natural rate”.

The problem is, this is the lens thru which most modern economists see the economy.  Money is neutral and so you can basically throw banks out of the system (this also explains why modern economists completely whiffed on the credit crisis – they said banks and bank money don’t matter to the economy).  Said differently, the idea of a natural rate of interest implies that an economy with banks will tend to converge towards an environment in which there are just goods and services (ie, money is just a veil).   As Keynes noted in the General Theory, many economists view(ed) the economy as a real exchange system as opposed to a monetary system.  This introduces all sorts of problems in the neoclassical model such as loanable funds theory, neutrality of money, NAIRU, etc.  In other words, the foundation of modern economics is based largely on flawed concepts that are much more along the lines of Wicksell and Friedman than anything Keynes actually believed in.

This brings us to the problem in Dr. Krugman’s Liquidity Trap view.  He thinks that the Fed can steer the economy towards the equilibrium point where the natural rate of interest will be hit and the economy will reach its potential.  But the problem is that this theoretical natural rate and real exchange system does not actually reflect the monetary world we live in.  The Fed is little more than a clearinghouse that sets a target interest rate on one type of money that impacts the economy and the bank lending rate in a loose fashion.  The Fed does not have the Archimedean lever that would give it the ability to get the economy to its full potential because its available policy tools are insufficient.  This isn’t a temporary situation.  The Fed’s inability to control the economy is not something unique to today’s environment.  It has always been true.  It just so happens that the crisis exposed this reality.  And if you take an operational view of the Fed, as opposed to this theoretical real exchange perspective, then all of this becomes much more obvious.

The reason I care so much about this is because it has distracted all of us from what could actually be helping us get out of this mess.  Most economists rely on these textbook narratives like the “liquidity trap” which states that “conventional” monetary policy has become impotent.  This implies that the Fed and other Central Banks just need to do something “unconventional” to get us out of this trap and help reduce real interest rates by raising inflation expectations.  And so we go thru the different iterations of “Quantitative Easing” and all of these other ineffective policies all the while distracting us from doing something that might actually help like tax cuts or public investment.  And the economic stagnation continues as we turn to “unconventional” monetary policy to help steer us towards the natural rate of interest.  And so it looks like we remain stuck in this permanent “liquidity trap” as economists say that “unconventional” policy just hasn’t been unconventional enough.  But all we’re really trapped in is a horror story written by economists who have a theoretical narrative that doesn’t actually reflect our reality.