I was reading Krugman’s latest blog post, and I was dumbfounded by the following comment:
I haven’t had an opportunity to ask him, but my guess is that he’s suspicious of quantitative easing, and would be more likely to side with the Fed’s inflation hawks than with those of us who think the Fed should expand its balance sheet, target higher inflation, and in general do whatever it takes to bootstrap ourselves out of the liquidity trap.
On my own blog, I have been sparring with a Keynesian by the name of D. Kuehn (he has his own blog, and also approaches Café Hayek). We’ve debated the concept of the liquidity trap, and so that immediately popped out. I wrote this as a comment on the blog (my comments are generally allowed through, but AFAIK my last one was not):
Prof. Krugman,
If a liquidity trap is a scenario in which further quantitative easing cannot lower interest rate, or stimulate lending and investment, then obviously according to you we are not in a liquidity trap. For the record, I don’t believe in the concept of the liquidity trap, either. I am just trying to clear what appears to be circular logic.
You write: “…those of us who think the Fed should expand its balance sheet, target higher inflation, and in general do whatever it takes to bootstrap ourselves out of the liquidity trap.”
If the Federal Reserve can target higher inflation, or in other words lower interest rates by increasing the supply of money, then we are not in a liquidity trap. I think it’s time for Keynesian theorists to go back to their textbooks and clarify a few of their theories. I’ve noticed that a large number of self-professed Keynesian economists don’t know Keynesian theories as well as Keynes’ opponents.
I feel that I might be splitting hairs, but a jab at Krugman is always worthy of the effort.
A liquidity trap occurs when the central bank hits the lower boundary of zero percent interest rates. The goal of quantitative easing is to overcome that by purchasing private debt, thereby expanding the money supply more and lowering interest rates more effectively than the traditional remedy of buying only government bonds.
Quantitative easing includes the purchase of government bonds (quantitative easing is just buying on the open market). For me, it’s a further disconnect between Keynesian theory and reality. I think Keynes operated with some understanding of capital theory, but since him Keynesian policies have become more and more detached. In any case, quantitative easing is just a means of increasing the supply of money (ultimately creating negative interest rates, once accounting “inflation”).
To me, it still sounds that there is an inherit contradiction between calling something a liquidity trap, and then suggesting that more quantitative easing will stimulate the economy. Traditionally, liquidity traps can only be overcome through government expenditure.
Though I would agree that modern Keynesian thought suffers from a huge disconnect from what Keynes actually said and believed, I don’t think that Krugman has necessarily erred from Keynesian doctrine. First of all, I think he would agree that we need fiscal stimulus to overcome the liquidity trap and that’s why he wanted a much larger version of Obama’s stimulus plan. Secondly, the point of quantitative easing is to do much more in order to push interest rates lower than what was traditionally done. Traditionally, central banks tinker with capital requirements, reserve requirements, and then they buy government bonds in order to lower interest rates. Quantitative easing, on the other hand, is when central banks go out and buy more government bonds, as well as private debt (e.g. corporate bonds), on the open market. This is able to directly push down interest rates for private borrowers. Though I agree that the whole point of a liquidity trap is that it’s impossible to create inflation through just lowering interest rates, I also think that Krugman thinks that quantitative easing in comination with fiscal stimulus is necessary to overcome a liquidity trap.
I think your definition is mistaken. Quantitative easing is a general term for when the central bank increases the supply of money (it is synonymous with making open market operations). Whether Krugman believes that further liquidity will work in conjunction with fiscal stimulus, in the former respect he is in contradiction with Keynesian theory (Keynesian, not Keynes’; the concept of the liquidity trap was not Keynes’). Quantitative easing, in the case of a liquidity trap, only works to increase excess reserves. During a liquidity trap, in Keynesian theory, the problem is not liquidity, it’s that the excess liquidity is not being loaned out for whatever reason (thus the name of “liquidity trap”).
Would it be correct to say that the reason liquidity is not being loaned out is due to the malinvestment that the economy is attempting to expunge? Does this imply that there is no mystery to the liquidity trap? Do “Keynesians” understand the cause of the liquidity trap, or do they think of it as being “mysterious”?
Nicely said, but you have to remember that Keynesian economics extends far beyond the works of Keynes. There was so much crap tossed together during “the synthesis” that Keynesians don’t know what they support.
It’s called the “precautionary demand for money,” which just means that the demand for cash rises during periods of uncertainty. Keynesians claim that individuals and businesses become so “irrational” during downturns that they simply won’t spend and reinvest–they are “captured” by “animal spirits.” The truth is that an increase in the demand for money in the narrower sense during cyclical downturns is the result of a malformed capital structure. The economy is saturated with malinvestments tying up real capital, and people merely want to maintain their positions, if they can. This will bid up the rate of interest and purge the system, freeing factors of production for more warranted economic activities. Also, an increase in the demand for cash (money in the narrow sense, or money proper) may mean a fall in the demand for fiduciary media (money in the broader sense).
They Keynesians don’t know that capital is heterogeneous, and therefore don’t understand the structure of production. With homogeneous capital you don’t have asset bubbles and capital ceilings. Thus, they turn to mysticism as an explanation (“speculation” and “animal spirits”).
I don’t think they draw the source of the liquidity fund as malinvestment. I’m not sure where they believe the source is at.
On a tangent, I think this PDF, hosted by the NY Federal Reserve, Iillustrates my point:
A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective. The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.
There was a shift in thought, and the new “literature” is obviously working off the old literature, and I think does not have good foundations on what the old literature was based on. That PDF is interesting, though, and cites some Krugman.
True, but I’m one of those who likes to differentiate between purist pre-synthesis Keynesians and fake post-synthesis Keynesians. Funny though, considering I’m an Austrian. Most people who make that differentiation are post-Keynesians who like to complain how anti-Keynes modern Keynesians are.
The Post Keynesians are confused Austrians who read Schumpeter more than Keynes. For Post Keynesians uncertainty is ontological, as opposed to Austrians who believe it’s epistemic. The existence of uncertainty is basically their justification for complete government control. They have no real economic doctrine, it’s basically: 1) Marshallian capital theory, 2) The theory of the firm, 3) Austrian monetary theory, 4) Dynamic efficiency (Austrian approach) + static efficiency, 5) Focus on aggregate employment (from Keynes), 6) Statism (they like Keynes because Keynes talked about the socialization of investment).
The New Keynesians were much more Keynesian than the Post Keynesians. They also hate math and see no place for it in economics.
I agree that the Post-Keynesians are confused, though I’m not sure if one could really consider the new Keynesians more Keynesian. The new Keynesians accept much of neoclassical economics for their microfoundations, which I find disappointing. I think the post Keynesians try to actually interpret Keynes, whereas the new Keynesians work off of modern and mainstream economic literature (peer reviewed papers and studies). Then again, I’m no expert on Keynes so I can’t really tell. I have yet to read any of his works. I tried to give General Theory a shot, but my eyes started to bleed. [+o(]
Keynes was a neoclassical Marshallian economist. His marginal efficiency of capital is pure marginalism, and his functions come straight from Marshal/Pigou (though he slandered Pigou his whole career). Post Keynesians talk more about the Treatise on Money, and The Tract to Monetary Reform, than they do about the General Theory. Keynes was into math and probability theory, something the Post Keynesians flatly reject. The IS/LM model, Philips Curve, and Keynesian Cross are all based on Keynes’ logic/theories from GT.
Time to get back to basics. In conventional Keynesian thought, investment and savings are two disjoint activities. Interest rates have nothing to do with the level of investment or saving in the economy. Instead, other factors, such as feelings of future business prospects (“the animal spirits”) for investment, and income or wealth (“marginal propensity to consume”) for savings, determine these respective levels.
For the economy to be in equilibrium, savings must equal investment. In the classical model, interest rates will always make sure that savings equal investment, but not so in the Keynesian model. Instead, the interest rate mechanism is broken, such that if savings and investment are equal, than it’s a mere coincidence.
In the Keynesian understanding, a recession is caused by too much savings in excess of investment. But since interest rates have no real influence, either a random event can bring savings and investment back into balance, or the government fiscally intervenes to correct the mismatch.
Later on, interest rates are re-integrated back into the model through the Keynesian-neoclassical synthesis, such as the IS-LM model. Because of the synthesis, the model would allow for both monetary and fiscal policy interventions, as well as the possibility for a liquidity trap.
Liquidity trap is an evolving concept within Keynesian thought, but in its current form, it is understood when monetary policy becomes ineffective when interest rates reaches the zero bound.
. . .
Here’s the deal with Krugman. He thinks there is a mismatch in the present economy, with too much saving and not enough investment. To solve this problem, the monetary lever could be cranked, but would be useless near the zero bound, because there is no room for pushing down interest rates any further. But that same monetary lever can push up prices, since no real bound exists for how high prices can go.
Krugman wants everyone to spend down their savings, not through lower interest rates, but through higher inflation. Investment is not even a factor, since interest rate policy has been rendered useless.
Here’s another way to think about a liquidity trap. In the Keynesian-Neoclassical synthesis model, there exists an optimal interest rate for full employment output. In a liquidity trap, the optimal interest would happen to be a negative interest rate solution. This is the equivalent of a “no solution” situation in algebra. But some macro economists have been hinting it may be possible to introduce a negative interest rate, like solving a square root problem with imaginary numbers.
Krugman’s solution would bring about a negative interest, in the sense that savings would be earning a negative rate of return because of continual inflation. Because savings is losing more value than what it can earn in interest, everyone would be better off spending it on something, than losing it for nothing.
Through a monetary expansion, with continual inflation, everyone would spend down their savings, until savings is equal to investment, thus bringing the economy back to full employment. LOL.