Academic journal article The Cato Journal

Some Observations on the Return of the Liquidity Trap

Academic journal article The Cato Journal

Some Observations on the Return of the Liquidity Trap

Article excerpt

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

John Maynard Keynes

By the mid-1990s, most macroeconomists had probably assumed that the concept of a "liquidity trap" was safely dead and buried. Many of the newer intermediate macro texts failed to even mention the term. It would hardly be the first time, however, that a seemingly discredited macroeconomic concept suddenly regained a measure of respectability. With prominent macroeconomists, such as Paul Krugman (1998), now offering advice on how Japan can escape from its liquidity trap, it is appropriate to look at some neglected historical and theoretical issues raised by that dubious concept.

Although it is easy to find definitions of the term "liquidity trap," (1) its original meaning and interpretation are somewhat unclear. For instance, what did Keynes actually intend when he used the term "liquidity trap" in the General Theory? How does the modern interpretation differ? How can we identify the existence of a liquidity trap? What policies can prevent its formation, or allow an economy to move out of an existing trap? What monetary policy is optimal in a liquidity trap? Until very recently, contemporary macroeconomists had given little thought to those questions. Many of the answers are surprising.

Keynes' View of the Liquidity Trap

There is so much ambiguity in Keynes' writings that it is difficult to know exactly what assumptions he was employing in his discussion of the liquidity trap. He probably did not intend the concept to apply only to central banks constrained by a rigid gold standard regime. (2) But there is no evidence that Keynes intended this concept to apply to a government embarked on a policy of almost unlimited creation of unbacked fiat currency, as occurred for example in Germany during the early 1920s (Sumner 1999). The only real-world example of the liquidity trap in the entire General Theory appears on pages 207-8, and refers to a situation where open market purchases by the Federal Reserve failed to boost the economy during the spring of 1932. Yet that is an odd case to cite because offsetting outflows of gold prevented the purchases of bonds from boosting the money supply (see Currie 1934, Laidler 1999).

The view that monetary policy might be ineffective during a depression was widely held during the interwar period, both in academia and in the financial markets. But those who held that opinion generally opposed an unconstrained fiat money regime (termed "greenbackism") for being likely to lead to high inflation as well as rapid exchange rate depreciation. And this seems to have been Keynes' view as well.

If Keynes' views on the effectiveness of monetary policy were constrained by exchange rate considerations, and if he believed that the sort of monetary expansion necessary to push an economy out of a liquidity trap would cause undesirable currency depreciation, then the Keynesian liquidity trap was actually an example of the theorem that it is impossible to hit two policy targets with one policy tool. This "two targets-one tool trap" bears no relationship, of course, to the liquidity trap as defined by modern theorists.

In volume two of the Treatise on Money, Keynes (1930: 372) briefly mentioned another factor that might result in monetary ineffectiveness. He noted that a central bank engaged in open market purchases might mn out of eligible assets before it was able to achieve its policy goals. Thus, if the Federal Reserve were restricted to buying only U.S. Treasury securities, and if the U.S. national debt were to be completely paid off, then the Fed's ability to boost aggregate demand would be severely constrained. …

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