Paul Krugman Does Not Understand the Liquidity Trap

trap_stiglitz

I came across a very amusing piece from Krugman in 2010. The piece is entitled ‘Nobody Understands the Liquidity Trap‘. Actually, Krugman might have a point — if we include him in the ‘everybody’ that does not understand the liquidity trap and thus conclude that he, and all those that listen to him, do not understand the liquidity trap.

You see Krugman confuses the zero-lower bound for the liquidity trap. But in doing so he completely scrambles the meaning of the term ‘liquidity trap’. Let us first get a feel for meaning of the term ‘liquidity trap’. Here is Keynes in the original. In the General Theory he writes:

There is the possibility… 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 event the monetary authority would have lost effective control over the rate of interest.

So, a liquidity trap is a situation when the central bank pumps in money and the rate of interest doesn’t respond. People say: “Meh, I don’t like the look of those bonds, I’ll just hold this cash”, and so bond prices remain low.

Krugman, on the other hand, has completely confused two concepts — that of a zero-lower bound scenario and a liquidity trap. You can see this clearly in his 1998 paper where he writes:

A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. (p141)

Um, no. A liquidity trap is when people say “nah, I don’t want bonds, I want money”. It is a situation in which the rate of interest on bonds do not respond to an increase in base money. Let us be clear: in a liquidity trap people do not want to hold bonds. In a liquidity trap cautious investors spit bonds back onto the market, their prices fall and their yields rise.

It is thus obvious that a liquidity trap occurs when the rate of interest gets ‘stuck’ and does not respond to an increase in base money. As I have argued before, we saw this in 2009-2010 when interest rates on risky assets failed to respond to Fed intervention. But we do not see this today. The central bank have not today, as Keynes puts it, “lost control over the rate of interest”. After 2009 interest rates came down across the board in response to actions by the central bank. Today it is well-known to even the most myopic mainstream economist that we live in a low yield environment.

What we do see is a zero interest rate. But that is just a zero interest rate. It is not a liquidity trap. We know this because bonds are still very much so in demand. Whereas in a liquidity trap people want to hold money instead of bonds. That is not the case today. Today people are desperate to get their hands on bonds because holding money is eroding their portfolios due to the substantial negative yield being incurred. But in a liquidity trap, as Keynes says, “almost everyone prefers cash to holding a debt”.

Let’s just get that straight: the key symptom that indicates that there is a liquidity trap is that people want to hold cash instead of bonds. Let me state that one more time in a different way: a liquidity trap is when there is a panic across financial markets, people rush to cash and no matter how much cash the central bank issues the demand for financial assets remains depressed.

Last week Janet Yellen said that she was concerned that people were too eager to hold junk bonds. And here are Krugman and the New Keynesian brigade telling us we’re in a liquidity trap. It is completely absurd. What has occurred is that monetary policy has failed to revive the economy. That’s a sad day for mainstream economists who have believed for over three decades that monetary policy is a panacea. But it is still not a ‘liquidity trap’. That term has a specific meaning. It is useful. Equating it with the central bank setting the interest rate near zero is equivalent to destroying the term and sucking it of its meaning.

It gets worse when you think this through in more detail. Recall that for Keynes a liquidity trap is when “the monetary authority would have lost effective control over the rate of interest”. But have the monetary authorities lost control over the rate of interest at the zero bound level? Nope. Anyone who has actually read Keynes’ great work knows that in it he discusses Silvio Gesell’s ‘stamped money’ which would be an obvious way for the monetary authorities to impose negative interest rates of their choosing. Keynes writes:

According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure.

(There are quite a few variations on this idea some of which I’ve noted before — although I’m not very enamored with the idea).

So even by the simple criteria of whether the monetary authorities have lost control over the interest rate it is obvious to any reader of the General Theory that they have not. No liquidity trap here folks!

Now, I know the response to this. “Ugh! You read too many books Phil! Reading books is for humanities students! I’m an economist, I do maths and stuff and I’m a really super serious sort of person that only cares about economic theorising, I don’t care what Keynes said or what other books say, I only care about Science,” says our typical mainstream economist.

Well, this is the thing: the actual concept of a liquidity trap is a very useful tool when applied to understanding financial markets; especially when they go into meltdown. Minsky, for example, uses it at critical points in his work. Meanwhile the Krugmanians deploy it as a fancy sounding word for what is a simple and banal concept: zero interest rates. They use it to give authority to the fact that their economic theory today ultimately says “the Fed can’t lower interest rates past zero therefore we cannot rely on them to revive the economy” which is so flagrantly obvious a monkey could have come up with it — indeed, those who have read Chapter 23 of the General Theory  on stamped money know that this statement is not even true and that our simian pal would be wrong.

“Hey, I want to hide the fact that I’m saying something banal so I’m going to use this fancy-sounding word that is in Keynes and is related to the ISLM,” say the Krugmanians. I’m saying rather that we should define the concept of liquidity trap properly because it is a useful and interesting analytical tool, especially when trying to understand what happens in a crisis scenario when the demand for cash really rockets and the monetary authorities really do find that they have lost control over the price of financial assets (and, hence, interest rates).

Which usage is closer to a ‘scientific’ usage. Well, only you, dear reader, can decide that. But that decision will likely be informed by how good an understanding you have of actual financial markets and how they affect the macroeconomy. Let’s just say that economists like Minsky are a better guide than people hocking the ISLM, easily the crudest tool ever invented by a Keynesian monetary economist (Hicks himself, who became quite a good monetary economist after that particular car crash, later basically said this lest we need be reminded).

If you want to understand nothing about financial markets read Krugman and play with the ISLM, if you actually want to understand how financial markets work read Keynes, read Minsky, read Harrod, read Robinson — hell, read Hicks’ more advanced work on money and financial markets. Oh, but then you might have to open a book and actually read it rather than twisting clearly defined concepts to cover up the fact that you’re basically saying nothing beyond the fact that central banks have near zero interest rates. Terrifying prospect.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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42 Responses to Paul Krugman Does Not Understand the Liquidity Trap

  1. philippe101 says:

    Philip,

    I’m trying to get my head round this. You say:

    “A liquidity trap is… a situation in which the rate of interest on bonds do not respond to an increase in base money.”

    Isn’t that what the ZLB is? At the ZLB, an increase in base money fails to bring down interest rates on bonds. So interest rates are ‘stuck’ and don’t go any lower in response to increases in base money. As you say:

    “It is thus obvious that a liquidity trap occurs when the rate of interest gets ‘stuck’ and does not respond to an increase in base money.”

    It seems to me that we weren’t in a liquidity trap before we ‘reached the ZLB’, as increases in base money succeeded in bringing down interest rates.

    • philippe101 says:

      Regarding Gessell’s ‘stamped money’ idea, Keynes says the following:

      “The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes — bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth. As I have mentioned above, there have been times when it was probably the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest; — though under Gesell’s system this possibility would have been eliminated by land nationalisation.”

    • Half way there. But people have to dump bonds. As Keynes says a liquidity trap is a situation in which “almost everyone prefers cash to holding a debt”. But investors LOVE bonds right now. That is why Yellen is saying that they love bonds TOO MUCH!

      • ali says:

        Bond is a kind of debt,however its quite liquid similar to the bank note! May be people feel about inflation and take even junk bond instated of completely leaving the debt(bond ) market.

      • philippe101 says:

        Phil,

        It seems to me that the trillions of excess reserves show that people want to hold that base money rather than bonds. If people wanted to hold bonds instead of that ‘cash’, those excess reserves wouldn’t exist – they would be converted into required (or desired) reserves as a massive amount of lending expanded the broad money supply (deposits).

        The fact that there are trillions of excess reserves indicates that currently people prefer to hold that base money rather than ‘lend it out’ (so to speak).

      • Are you saying that all those reserves could flow into the debt markets, Philippe?

        Are you also saying that banks are sitting on borderline zero-yield cash by choice? Because that’s not what the banks are saying…

      • philippe101 says:

        “that’s not what the banks are saying…”

        what are the banks saying?

      • That they’re being shafted with reserves that they can’t do anything with but hold at the central bank. That they want the central bank to reverse QE and reissue those tasty yielding securities that they took away in 2008.

      • philippe101 says:

        ok, but they’re not ‘lending them all out’, i.e. converting them into required or desired reserves by making loans and increasing deposits. So this huge quantity of excess reserves is being held, rather than the alternative.

      • If they lent them out they would accrue as reserves anyway… Bank lends to you, you invest, funds wash through to another bank. Excess reserves would continue. Same if a bank uses them to buy shares or bonds. It’s a closed system.

        Flooding the system with reserves just means what it says. The banks can never get rid of them. Only the CB can do that. Isn’t that what the MMT folks are always saying?

      • philippe101 says:

        “If they lent them out they would accrue as reserves anyway… ”

        yes, the banking system as a whole can’t ‘get rid’ of aggregate reserves (although some would leave the banking system as cash in circulation, as borrowing and lending and deposits increased).

        However, by increasing lending, and thereby increasing deposits, banks can get rid of excess reserves. This is because excess reserves gradually get converted into required, or desired, reserves as more loans are made and deposits increase.

      • Well, it certainly won’t happen if that money is circulated through the debt markets. I.e. if it is used to buy more bonds because no extra deposits will be created.

        What we have now is not a “liquidity trap” but what the ISLMists call an “investment trap”. In ISLMese that is when the IS curve is vertical.

      • philippe101 says:

        Keynes says debt rather than bonds in the quote you posted above. But anyway, if there was more lending in the debt markets, i.e. if people ‘wanted to hold bonds’ instead of ‘holding’ the excess cash reserves, this increased lending and borrowing would mean more spending (on investment and consumption), which would lead to upward pressure on inflation and interest rates, meaning that the economy would be on its way out of the ‘liquidity trap’.

        At some point the CB would then start to raise the base rate/ withdraw the excess reserves.

        The problem is how to make this happen..

      • philippe101 says:

        It seems to me that your explanation doesn’t make sense, as Keynes clearly says that

        “There is the possibility… 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.”

        He’s clearly talking about very low rates of interest, but you seem to think that a ‘liquidity trap’ means high interest rates…..?

      • He says “a certain level” and then says that investors see this level as “too low”. It might be low. It might be high. These are relative terms. The point is that debt/bonds/whatever are rejected in favour of cash. That is NOT happening today and has not happened since late 2009. Read Minsky on this. He’s very good.

      • philippe101 says:

        you said the economy was briefly in a liquidity trap in 2009, but I don’t see how that could be so, given that interest rates fell sharply as the supply of base money increased. In contrast, when we hit the ‘ZLB’, interest rates wouldn’t go down further, regardless of how many trillions of cash were injected into the banking system.

        If the CB can bring interest rates down, then it hasn’t “lost control over the rate of interest”. At the ZLB, however, it loses the ability to push rates down further (unless it can go negative….).

      • Interest rates rose. They didn’t fall.

        Are you confusing the overnight rate/T-Bill rate with private interest rates?

      • philippe101 says:

        “Interest rates rose. They didn’t fall.”

        They rose briefly, then came back down. If there is a ‘liquidity trap’ then rates are ‘stuck’, as you say, and the CB can’t bring them down by printing more money.

      • Almost a year isn’t very “brief” in my book.

        They fell when the markets unfroze after the bailouts were initiated. It was moreso TARP that fixed the problem than QE per se. Although the latter probably contributed. Randy Wray has done good work on the TARP issue and the loans extended etc.

  2. LK says:

    Just to clarify: the New Keynesian reasoning is that in order for monetary policy to work (under the loanable funds model) you need to make interest rates negative (pay people money to borrow) to clear the loanable funds market. But of course you can’t do this: the zero-lower bound stops monetary policy from working.

    Is this a fair summary, or have I misunderstood?

    • LK says:

      Correction:
      “the New Keynesian reasoning is that in order for monetary policy to work under what they call the liquidity trap ….”

    • Yes. But you can lower interest rates to negative by imposing negative interest rates. There are a few ways to do this.

      • philippe101 says:

        Keynes appears to think that it would be difficult to solve the problem with a negative interest rate:

        “The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes — bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth. As I have mentioned above, there have been times when it was probably the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest”

      • philippe101 says:

        “foreign money, jewellery and the precious metals generally, and so forth”

        I might be wrong, but this seems to suggest that he thought the result of a negative interest rate might be an increase in financial and real asset prices, though not necessarily an increase in spending on goods and services. This seems pretty close to what we’ve seen.

      • So am I. It’s Krugman et al who make that case. I’m just saying that it could potentially be done.

        As you say: it would just wash into assets. Stocks would become an “inflation hedge” as they so often are.

      • philippe101 says:

        “As you say: it would just wash into assets.”

        right, but Keynes seems to think it would wash into assets because of the desire for liquidity, once the liquidity premium of cash was reduced as a result of the negative interest rate. So he’s talking about a ‘liquidity trap’ situation, at very low/ negative rates of interest.

      • No. No mention of liquidity trap here. You’re confusing two chapters that are hundreds of pages apart. This is getting a little disorganised now…

      • philippe101 says:

        I was assuming, as he is talking about people seeking liquidity in other things once the interest rate goes negative.

        Could you post some more quotes from Minsky on the subject of the liquidity trap? At present I’m worrying that you may have this whole thing completely wrong… no offence!

      • philippe101 says:

        thanks. Some interesting comments there – I can begin to see a bit better where you’re coming from. Have you spoken about this with Paul Davidson for example (he comments here quite a lot)?

      • I haven’t really spoken with anyone about it. It’s developed in Minsky to show what happens after a financial crisis. It is a coherent theory. I used to talk to Stockhammer in private about it. He seemed to think that the Minsky interpretation was the mainstream in Post-Keynesians circles.

        But even if its not the Post-Keynesians don’t think that monetary policy is the problem anyway. So, I won’t have much impact there. Krugman is talking rubbish though. None of his macro makes any sense. He’s an awful monetary economist. It’s not even his field.

  3. psychonomist says:

    This is your Keynes quote: “There is the possibility… 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 event the MONETARY AUTHORITY would have LOST EFFECTIVE CONTROL over the rate of interest.”

    And this is you Paul Krugman quote: “A liquidity trap may be defined as a situation in which conventional MONETARY POLICIES (what Keynes calls monetary authority) have become IMPOTENT (=lost effective control), because nominal interest rates are at or NEAR ZERO (Keynes calls a low rate): injecting monetary base into the economy has NO EFFECT(=lost effective control) , because base and bonds are viewed by the private sector as perfect substitutes.”

    When you say “Krugman, on the other hand, has completely confused two concepts” its clear you are VERY LOST there. Krugman just rephrased Keynes’ words. Besides, in your own words you say “So, a liquidity trap is a situation when the central bank pumps in money and the rate of interest doesn’t respond.” Now any sane person who reads your JMK and PK quotations will see that you took the words of PK (who again was rephrasing JMK)

    Now moving on to Yellen. Its clear that what causes the liquidity trap are low interest rates. Now if people have an appetite for JUNK bonds (underline junk), it is because they pay higher rates. They shun conventional bonds and would rather have cash or junk bonds.

    Sorry when I got to the paragraph on Yellen I couldnt continue. I had had enough!!!

    • Wrong. Read carefully. Keynes says that a liquidity trap is when…

      …almost everyone prefers cash to holding a debt…

      Do you think that “almost everyone prefers cash to holding debt” today? Yes or no?

      • psychonomist says:

        When Keynes was talking of debt there its obvious he meant government debt (Which is very different from JUNK bonds). Not everybody prefers cash to debt as you want to hear because some people are buying Junk bonds, which, as you should deduce from this Keynes statement “In this event the monetary authority would have lost effective control over the rate of interest.”, are not under the EFFECTIVE control of monetary authorities

      • Is it obvious? Because I don’t think it is at all. And nor did later authors who interpreted Keynes to mean actual market interest rates as these are the ones that are (supposedly) important for investment decisions.

        When he talks about “cash” he is much more likely to be talking about “cash substitutes” (see here for financial market use of the term). It was the vulgar Keynesians like Krugman that pretended otherwise. And due to this, frankly, their macroeconomics makes very little sense.

    • Kora says:

      Yep, Krugman and Keynes are saying the same thing.

      This reminds me of the frequently occuring Post-Keynesian claim that economies are always demand-constrained, that Keynes said so (and then the usual bastard or vulgar Keynesian insult follows). They ignore that Keynes wrote ample of times in the GE that he considers classical theory to apply in the long-run, that the Neoclassical synthesis is not an invention of Samuleson but of Keynes.

      Now if the Post-Keynesians would just claim that they think that economies are always demand-constrained this would be fine as there are good reasons to think so. But hiding behind Keynes (and getting him totally wrong the the process) is just pathetic.

      • Hi Kora, we try to be a little academic on this blog so maybe you can provide some citations to support the case that Post-Keynesians “claim that economies are always demand-constrained, that Keynes said so”. Because to my knowledge the attempt to extend Keynes’ analysis to the long-run quite consciously started with Joan Robinson in the 1940s and 1950s. I have no problem with you launching critiques in my comments section. But comments like the above just make you come across as, well, I’ll be frank: a badly read idiot.

        And what any of this has to do with Keynes and Krugman on the liquidity trap is anyone’s guess. My reading is that the above post annoyed you and you got a bit emotional and started ranting about something you had not read up on properly. That comes across poorly on you. Fortunately, you are not using your real name. Thank heavens for that, eh?

  4. Miguel says:

    Sorry. It was in 2009

  5. Savings accounts or Individual Retirement Accounts for someone before age 59.5 yield .001 on average across the board at all banks. So, it seems that spending or investing should be preferable to holding money at zero interest rate. However, if the money is invested, it is no longer accessible for a period of time, there is a transaction fee on any action taken with it and there is a tax on any dividend. In effect, this means that there is a negative interest rate if you invest. If both consumption and investment are done, one inference is that people are trapped with their liquidity. A liquidity trap by any other name is still a liquidity trap.

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