Capitalism can go wrong in many ways. However, a favourite practice of Keynesian economists is to allege that the economy suffers from “the liquidity trap” (or “the classic liquidity trap”, in the case of Paul Krugman). In that trap monetary policy is said to be useless, ineffectual or impotent, so that governments must instead rely on “fiscal policy” (which usually means extra public expenditure) if they want to boost demand, output and employment. Yet “liquidity trap” is at very best ambiguous, and, whatever it might mean, it is one of only a range of pathologies. Some of the pathologies, including the various liquidity traps, are concerned with a problematic demand-for-money function, but others – such as Irving Fisher’s debt deflation idea and Hawtrey’s credit deadlock – refer to a breakdown in the private-sector money creation process.
We should take issue, in particular, with thinking such as that exemplified by Gavyn Davies writing in the Financial Times. He is one of those who claim that in the 1990s Krugman revived Keynes’ liquidity trap notion. In fact, the situation that worries Krugman (“the zero bound”) is quite distinct from the liquidity trap. The two notions should not be confused. Davies also says that the current alleged liquidity trap should be positive for equities relative to bonds. I agree with Davies’ investment conclusion, but not with the argument he uses to get there. In fact, equities are likely to advance over the next few years because a resumption of money growth is associated with excess demand for assets in general, and particularly for corporate equity and real estate. These patterns have nothing whatever to do with the liquidity trap in any shape or form.
Some overriding questions
Was capitalism to blame for the Great Depression and the Great Recession? And if the answer is ‘yes’, is capitalism inherently flawed? No one disputes that something has gone wrong with the economies of the advanced Western nations since 2007. Output has fallen far beneath the trajectory that might reasonably have been expected from trends over the preceding 60 years. Indeed, for a number of significant countries official data say that output remains beneath the previous peak. (In the UK’s case output in the second quarter of 2008 is estimated to have been about 2 ½% higher than at the end of 2011.) The setback has been so severe as to raise doubts about the efficiency and even the legitimacy of the prevailing system of economic organization, namely market capitalism where individuals own, manage and trade private property subject to the rule of law. For some the Great Recession is proof of the inadequacy of the capitalist system in the contemporary context, just as the Great Depression was proof of the inadequacy of the capitalist system in the 1930s.
An example of the dissatisfaction now being expressed about market capitalism is a series of articles on the op-ed page of the Financial Times, under the title ‘Capitalism in Crisis’. The usual focus of these articles is an alleged failing of some kind in the financial system. Indeed, the vulnerability of the financial system to public criticism is a long-standing feature of the capitalist world, and the criticisms echo centuries-old religious strictures on usury, debt and so on. The criticisms are sometimes little more than elaborations of ancient and rather silly prejudices. However, more heavyweight critiques of capitalism have been expressed by, for example, John Maynard Keynes in his 1936 General Theory of Employment, Interest and Money, a book commonly seen as providing intellectual justification for extensive public ownership and hence for “the mixed economy”.
In the General Theory Keynes developed a sophisticated thesis that, in certain circumstances, monetary policy would not be sufficiently powerful to boost demand, and to maintain output and employment. His target was the quantity theory of money, that nominal national income is related to the quantity of money, and that the change in the price level ought to be similar to the change in the quantity of money (after allowing for the increase in real output, reflecting an economy’s supply-side improvements). In his day the Treasury opposed public works expenditure and active use of fiscal policy, on the grounds that the state could always expand the quantity of money. Ralph Hawtrey – in effect the Treasury’s chief economic adviser – was Keynes’ most important antagonist and took a traditional, rather Victorian line on the appropriate limits to state action. He argued that, because an increase in the quantity of money was a necessary and sufficient condition for an increase in national income, that is where policy measures should be concentrated.
Keynes’ protest against Hawtrey and the Treasury in The General Theory was complex. He pointed out that investors balanced their wealth between money and non-monetary assets, with bonds (paradigmatically, fixed-interest government securities) taken to represent such assets in general. He also claimed that an increase in the quantity of money had its stimulatory effect on the economy via “the rate of interest”, by which he meant the yield on bonds. In normal circumstances an increase in the quantity of money would cause a rise in the price of bonds and a fall in “the rate of interest”, which would stimulate investment and hence demand as a whole. But suppose that the price of bonds is very high and the bond yield (i.e., again, to repeat, “the rate of interest” in Keynes) unusually low. Then investors are sensible to fear the next major move in the bond price may be downwards, delivering a capital loss. As a result, when the state increases the quantity of money, investors allow the ratio of money to their total wealth to rise, possibly without limit. (In jargon, “the elasticity of the demand to hold money balances, with respect to the rate of interest, is infinite”.) Monetary policy is impotent. On this view reliance must instead be placed on fiscal policy, with the further implication that investment ought to be partly “socialised”, that the government must use its power to spend and tax to manage demand, that “high employment” was the responsibility of the state, and so on. In a 1940 paper Dennis Robertson gave the name “the liquidity trap” to the circumstances (i.e., the infinite elasticity of money demand) imagined by Keynes. The phrase has stuck. (Robertson had a low opinion of the trap, incidentally.)
More recently, Paul Krugman, a Nobel prize winner and pundit on The New York Times, has resuscitated the phrase “the liquidity trap”. He has further asserted that – because in his judgement the USA and Japan suffer from a supposedly “classic” version of the trap – both countries should embark on large-scale public works expenditure to boost employment. There is little doubt that Krugman sees himself as Keynes’ successor and as a critic of “monetarism”, where monetarism is to be understood in rather loose terms as embracing the claim that the active use of monetary policy instruments ought to be sufficient to stabilize the economy.
However, I have pointed out in several places that Krugman’s trap is different from Keynes’ and not a “classic” one at all. (The most extended treatment is essay 4 in my recent book Money in a Free Society.) A problem here is the multiplicity and rather kaleidoscopic nature of Krugman’s writings, which make it difficult to pin down and elucidate exactly what he means. What is clear is that Krugman is really worried about the inability of the central bank to push “the rate of interest” beneath zero. Plainly, if companies and investors expect future falls in prices, a zero nominal rate of interest implies a positive real rate of interest. Indeed, that positive real rate of interest may check investment, hold back demand and lead to high unemployment.
In his feature in the Financial Times on 25th January Gavyn Davies of Fulcrum Asset Management gave a short (and not altogether satisfactory) account of Keynes’ trap, referred to Krugman as the “reinventor” of the liquidity trap notion, and managed to invent another one himself! As I pointed out in a letter to the Financial Times on 31st January, Davies’ trap was in fact a mix of the Keynes and Krugman traps. (I will discuss the different trap situations in more detail below). Davies went on to argue that equities ought to outperform bonds in the current alleged “liquidity trap”. I happen to agree with Davies that now is a good time to be investing in equities, and certainly to be investing in equities rather bonds. However, I am underwhelmed by the argument he presents for his conclusion, and am sure that his conclusion has nothing whatever to do with the liquidity trap in any shape or form.)
In the background to the discussion of the various traps are deeper political commitments. The gravamen of Keynes’ ideas in The General Theory was that capitalism was unstable and so inherently flawed. Keynes never said explicitly that capitalism was to blame for the Great Depression, but his Keynesian successors have made numerous statements along these lines. Krugman is well-known as an articulate and influential member of the Democratic Party, and as a “liberal” in the modern American sense (i.e., a believer in government intervention to help the less well-off and unfortunate). The references to the liquidity trap in Krugman’s writings are part of a larger intellectual assault on free-market capitalism and certain perceived excesses of its financial system. Davies was prominent in the New Labour cause in the 1990s, and is believed (perhaps incorrectly) to have remained influential in Labour Party circles during the premiership of Gordon Brown. My guess is that both Krugman and Davies would say that capitalism was to blame, at least to some extent, for the Great Recession. Both also see active fiscal policy (i.e., an increase in the budget deficit) as superior to stimulatory monetary policy in promoting demand, although – I suspect – Davies would prefer low budget deficits if there were no conflict with demand management issues. (One of Davies’ claims to fame is that he proposed the framework of fiscal stability – namely, the golden rule and the sustainable investment rule – that was adopted by the last Labour government in its early years. Of course this framework did not survive the Great Recession. Labour responded to the Great Recession with a vast expansion of the budget deficit, with which the present Conservative-Lib Dem coalition is grappling.)
Several ideas have been proposed to characterise either the inherent instability of capitalism or the inability of capitalism to restore full use of resources by itself once heavy unemployment has emerged (i.e., the economy suffers from “an under-employment equilibrium”). Further, each of the traps has a number of variants. Five categories of trap are discussed below, with brief criticisms.
1. Keynes’ “liquidity trap” in The General Theory
I have already described this above. The essence of Keynes’ trap is that an increase in the quantity of money (by which Keynes undoubtedly meant a money measure dominated by bank deposits) does not reduce the yield on bonds (i.e., Keynes’ understanding of the phrase “the rate of interest”), so that investment does not respond to an increase in the quantity of money. (I explained why Keynes’ story makes sense only if the money aggregate includes most bank deposits and therefore assumes a broad definition in money on pp. 83 of Money in a Free Society. In my book I therefore called Keynes’ trap “the broad liquidity trap”.) Further, because national income is a stable multiple of investment in crude textbook Keynesian stories, national income also does not respond to an increase in the quantity of money.
In my view the broad liquidity trap in The General Theory is a fatuous – indeed incredible – idea as soon as one starts to think about real-world economies. The plausibility of the “classic” liquidity trap in The General Theory depends entirely on the assumption that portfolio balance is defined in terms only of money and bonds. In the real world agents are also balancing money against
i. Goods and services, i.e., they have a desired ratio of money to expenditure and incomes, and
ii. A range of non-monetary assets apart from bonds, including corporate equity and real estate, i.e., they have a desired ratio of money in their equity and real estate portfolios, depending on the type of investor that they are.
In the real world a significant increase in the quantity of money must always boost asset prices in general and so stimulate the economy. (For more detail, see an important and fascinating recent paper ‘The impact of QE on the UK economy – some supportive monetarist arithmetic’ by Jonathan Bridges and Ryland Thomas, Bank of England Working Paper no. 442. Bridges and Thomas envisage some overshooting of asset prices – and not just bond prices – after a sudden large injection of money balances.)
2. The problem of the zero bound
The problem that nags Krugman is quite distinct from Keynes’ liquidity trap. In the relatively stable period of the Great Moderation central banks were fortunate that small movements in the money market rate (usually achieved by means of repo operations) were sufficient to keep economies wellmanaged and stable. The money market rate is variable and closely related to inter-bank rate, and it is not at all the same thing as “the yield on fixed-interest bonds”. Moreover, repo operations – and indeed all transactions between the central bank and commercial banks – have no direct effect on the quantity of money, which consists of money balances (mostly bank deposits) held by non-banks. In the Great Recession the central banks drove the money market rate down to zero and, unfortunately, still found in early 2009 that macroeconomic conditions were deteriorating. They appeared to be in a trap, the trap of the zero bound, in which “monetary policy” (defined in terms of open market transactions between the central bank and the commercial banks) could do nothing more to boost demand.
So the zero bound problem relates to the inability of central banks to push the money market rate (i.e., a very common understanding of the notion of “the rate of interest”) beneath zero by operations on the monetary base. Normally that should not cause wider difficulties for the economy, because – as long as the quantity of money is stable or growing – a zero interest rate ought to be associated with at least trend growth in demand and output. However, there are extensions of the zero bound notion in which a capitalist market economy appears to be trapped.
First, as Davies has said of Krugman’s various discussions, agents may suffer in the zero bound from expectations of a falling price level. In that case borrowing can be done only at a positive and possibly quite high expected “real rate of interest”. Investment is deterred, demand weakens and so on. I am not entirely sure whether Krugman sees this as an unstable, self-reinforcing process of macroeconomic disintegration (like Fisher’s “debt deflation” idea, considered below) or as a stable, but unsatisfactory underemployment equilibrium. At any rate, it is bad news. If one believes (as Krugman apparently does) that monetary policy consists solely of operations on the monetary base by the central bank to determine the money market rate, monetary policy has indeed become ineffective.
My answer to Krugman (and Davies) is very simple. They have overlooked that the state has a number of methods available to boost the quantity of money directly, without regard to the monetary base. Aggressive, large-scale purchases of assets from non-banks by either the government or the central bank (i.e., “quantitative easing” in the British sense, the actual policy adopted by the Bank of England in March 2009) can, when financed by the banking system, create extra money balances without limit. (They may also affect the monetary base, but that is not their immediate intention.) I have no doubt that such operations can stimulate the economy, because – as I said above – I have a low opinion of the plausibility of Keynes’ broad liquidity trap.
But there is more to say. A second elaboration of the zero bound notion considers not the interaction between the nominal interest rate, deflation expectations and the real interest rate, but the danger that the banking system will not want to grow even at a zero interest rate. After all, in normal conditions one would expect a zero interest rate to be accompanied by rapidly growing bank credit to the private sector and hence by fast growth of the quantity of money. Regrettably, there may be conditions in which either banks do not want to expand their assets (perhaps because they are capital constrained) or banks’ customers do not want to borrow from them (perhaps because asset prices have fallen and their balance sheets are stretched), even when the money market rate is zero. So the quantity of money does not expand in response to central bank injections of monetary base, even at a zero interest rate. In Money in a Free Society I called this state of affairs “the narrow liquidity trap”. It is a kind of liquidity trap, but it relates to banks’ demand function for monetary base (which is in effect infinitely elastic) and the monetary base, not to nonbanks’ demands function for the quantity of money and the quantity of money. There is little doubt that Japan and even the USA have succumbed to the narrow liquidity trap in the Great Recession. (Indeed, in Japan’s case it has been in a narrow liquidity trap for 20 years or so.)
Krugman would have been right to use the “liquidity trap” phrase if he had alleged that the USA and Japan have had to endure a narrow liquidity trap at some points in the last decade or two. However, Krugman has not in fact set out a description of a narrow liquidity trap (i.e., a trap with a money demand function of some sort, exhibiting extreme elasticity over a certain range) in his various papers and articles. (In fact, I show in essay 4 in Money in a Free Society that Krugman has at least three other liquidity traps scattered in his assortment of writings, with different mechanisms, processes and equilibriums in play in all of them. It is a magnificent hodge-podge of ideas.)
What about Davies’ trap? In the Financial Times article he proposed a “full” liquidity trap in which short-term rates are at or close to the zero bound and bond yields are so low that they cannot realistically go any lower. So Davies’ trap combines elements of both Keynes’ and Krugman’s traps! I have nothing much to say about Davies’ trap here, except to comment that for once too much of a good thing may be less than wonderful. In fact, it may needlessly confuse matters.
3. Hawtrey’s “credit deadlock”
I said earlier that Keynes’ main antagonist in the policy debates of the 1930s was Ralph Hawtrey at the Treasury. Hawtrey was sceptical about the liquidity trap idea, believing that officialdom could always create enough money and halt a recession/depression by that means. But he did develop his own trap idea, which he termed a “credit deadlock”. To quote from his 1937 book Capital and Employment, published as the debate on Keynes’ General Theory was gathering momentum,
Traders who are already encumbered with excessive stocks cannot be induced by any facilities that may be offered them for borrowing money to add to their stocks. And even those who have succeeded in reducing their stocks, but have suffered in the recent past from…miscalculations, will think much more of avoiding redundant stocks than of the minor advantages of buying convenience. Under such conditions “cheap money” or extremely low rates of short-term interest, may fail to evoke revival…A complete deadlock may result.
Notice that the credit deadlock idea is again quite distinct from either the liquidity trap or the problems discussed above under the zero bound heading. Both the broad and narrow liquidity traps are pathologies that arise from perversity in a demand-to-hold-money schedule. The credit deadlock, on the other hand, is a pathology in which money creation comes to a stop because the private sector, “encumbered with excessive stocks”, does not wish to borrow from the banks and thereby create money. It is a pathology due to an interruption of the growth of bank credit and a consequent inadequate supply of money balances.
Nevertheless, it remains true – even in a credit deadlock that halts the expansion of the quantity of money by the private sector – that the state can create money without limit by large-scale asset purchases (i.e., by QE).
4. Irving Fisher’s “debt deflation” process
Irving Fisher’s debt deflation process, first described in the 1933 issue of Econometrica, is also concerned with a breakdown in the private sector’s money creation process, but it is appreciably more vicious than Hawtrey’s credit deadlock. Fisher’s idea was made more persuasive by the high leverage that characterises most banking systems. Assume that, for whatever reason, the quantity of money has fallen. The money contraction undermines asset prices, the banks suffer losses on their loan portfolios, the losses wipe out part of the banks’ capital (or all of it in some cases), the banks react to the depletion of their capital by dumping securities and pulling in loans, the dumping of securities and pulling in of loans leads to further money contraction, the money contraction again undermines asset prices, and so on. Plainly, in certain extreme cases these processes can be unstable. The central bank can try to counter them by cuts in short-term interest rates, but sometimes these cuts in short rates may not be sufficient to offset the adverse forces that are causing banks to shrink their balance sheets and to reduce their monetary liabilities.
Conclusion? Please use words carefully
This note does not have any strong conclusion for either investment strategy or public policy. I want merely to insist that free-market capitalism has many pathologies and that it is a mistake to believe, like Krugman, that they can all be captured by the phrase “liquidity trap”. In advancing his policy nostrums, Krugman has undoubtedly exploited Keynes’ name and the attribution of an allegedly “classic” liquidity trap notion to Keynes. He has used them as intellectual brand names to support his push for extra public expenditure and a higher budget deficit. Non-specialists need to note that
1. Free-market capitalism has many pathologies of demand weakness, and it is pure sloppiness on the part of macroeconomists (including Nobel Prize winners like Krugman) to apply the phrase “liquidity trap” indiscriminately to all of them, &
2. the various pathologies are sometimes non-monetary, but for the most part involve a delinquency of some sort inside the banking system or in the relationship between banks’ customers, their money holdings and some other variable.
In my view none of the pathologies refute the claim that the state can always increase the quantity of money (in the extreme without limit) and so prevent a major slump in demand.
Tim Congdon is the founder of International Monetary Research Ltd.