Di Bucchianico on Krugman and the Liquidity Trap

New paper on the problems of Krugman and the Liquidity Trap argument (some will be able to download if for free, and I recommend this version; however, there is a previous working paper linked at the bottom for those unable to open).

From the abstract:

Krugman’s ‘liquidity trap’ model constituted a ground-breaking contribution by attributing the long-lasting Japanese stagnation to a negative natural interest rate. Our critique to such a proposal will focus on three aspects. First, we will question the logical structure of the model, providing an alternative interpretation of its closure and arguing that aggregate demand has no crucial role in it. Second, we will argue that a negative natural interest rate can emerge only after a series of overtly restrictive assumptions in a model that does not treat capital and avoids long-run equilibrium analysis. Finally, we will discuss the mainstream literature which followed up until the recent rediscovery of the Secular Stagnation Theory. Within that line of literature, the key features of the ‘liquidity trap’ model continue to occupy a prominent role, thereby letting the critical issues that have been singled out resurface. Our conclusion is that the ‘liquidity trap’ explanation did not provide a satisfying rationale for Japan’s stagnation and cannot describe later economic predicaments either. A comparison with Post-Keynesian models shows their ability to offer insightful policy prescriptions without relying on those shaky theoretical foundations.

Note that an important part of the argument is the critique of the natural rate of interest, something we have done extensively over many years in this blog, and of the notion of a negative one in the context of Summers' discussion of secular stagnation (also done in this blog; see for example here and more recently here in the context of a debate with Stephanie Kelton and MMTers; btw her book is out and anybody wanting to reviewed it for ROKE send me an email; I look forward to reading it too).

The important thing in the paper is that it goes beyond the capital debates critique, and shows the extra restrictions needed for Krugman to get his results, including some interesting thoughts on the problems associated with intertemporal models.

PS: ROKE will soon publish a paper by Serrano, Summa and Garrido Moreira (Fall issue) in which other limitations of the negative natural rate are explored.

PS': Link to working paper here.

Summers on secular stagnation, the ISLM, and the liquidity trap

Two short clips from Lawrence Summers talk at the ASSA meeting in San Diego. So he first says that secular stagnation is more plausible now than before. He sees that it can be explained as a shift of the IS curve backwards. His IS has a somewhat marginalist foundation, with a natural rate, and a fairly conventional story for investment. Of course, the negative shift has bee compensated by some sort of stimulus, that is now weaker. I would say a smaller multiplier that affects the slope of the IS would make more sense.

And he does say in the next clip that the IS is steeper, and the LM is flat, or that we are in a liquidity trap. Again, I think it's not really that, and simply a policy decision of the Fed, inevitable given the circumstances, perhaps.

He also, is not optimistic on monetary policy, and is pushing for expansionary fiscal policy. And certainly, even if there are many differences in the way I would portray the current macroeconomic situation, in particular the causes of the slow recovery and what he calls secular stagnation, on the policy issue we are not that far.

Liquidity preference and effective demand

Reading The Battle of Bretton Woods, by Benn Steil, an interesting book with some problems associated to its conventional economics analysis, I was struck by the following phrase: "Keynes had struggled for years ... to induce a compelling theoretical cause for his burning belief that investment could, even under flexible prices, fail to harmonize savings in a way that would maximize aggregate income. ... It was the concept of ´liquidity preference,' or the idea that people might choose to hoard inert cash rather than consume or invest the fruits of their labor."

It is improtant to remember how Keynes himself suggested he developed Liquidity Preference, to put Steil's argument in perspective. Keynes says in his "Alternative Theories of the Rate of Interest" (1937, p. 250; subscription required) that:

"the initial novelty [in his General Theory] lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments which lead up to this initial conclusion are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory."

In other words, the central idea of the GT is effective demand (investment determines savings through the multiplier) and liquidity preference is more or less an afterthought, developed to deal with the fact that by eliminating the Loanable Funds Theory he had left "the rate of interest in the air" (ibid.). Further, note that the situation in which "people might hoard cash," corresponds to the so-called Liquidity Trap.

In other words, when everybody expects that in the future the rate of interest will increase, and prices of bonds will collapse, and hence there would be windfall losses, there might be an absolute demand for liquidity [in spite of Krugman, not the case now]. What did Keynes have to say about the liquidity trap? In chapter 15 Keynes tells us ‘after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute … [b]ut … I know of no example of it hitherto’ (Keynes, 1936, p. 207). In other words, a downward rigidity of the rate of interest, while possible in theory, was not in practice the cause of unemployment for him, and certainly it was not the "compelling theoretical cause for his burning belief that investment could fail to harmonize savings in a way that would maximize aggregate income."

There are several other issues with the book, which I'll discuss in other posts.

The usual rules of economics

Krugman continues to defend his activist policies on the basis of the 'liquidity trap.' Beyond the usual confusion criticized several times here, he says that: "some of the usual rules of economics are in abeyance as long as the trap lasts. Budget deficits, for example, don’t drive up interest rates; printing money isn’t inflationary; slashing government spending has really destructive effects on incomes and employment." So according to him usually you have crowding out (higher interest rates with higher deficits), inflation is demand driven and caused by money printing (exogenous money), and cutting spending has no effect on employment (expansionary contractions).

None of this holds in normal times either, and he should know better. The evidence for the effects of budget deficits on interest rates, even in normal times, is not particularly favorable to the crowding out argument. The effects of a higher deficit-to-GDP ratio on long-term interest rates tends to be small, when it's statistically significant. And arguably even that small effect might be due to reverse causality, that is, the higher interest rate causes higher financial spending and higher deficits.

The same problems of causality plague the relationship between money and inflation too. And it has been accepted by almost everybody that central banks, always and not just in liquidity traps, control the rate of interest, not money supply. Unless you really believe that the economy in normal times is at full employment. If unemployment is the normal situation, then that would mean that the Fed sets the rate of interest, money supply is endogenous, and inflation, if it does exist, is cost driven. And if you really think that the 1970s inflation in the US was casued by money printing rather than the oil shocks and wage resistance, then it's hard to take you seriously.

Finally, wait, does he seriously think that, in non-liquidity trap periods, if you cut spending, then income and unemployment don't increase? I guess Okun's Law only works during liquidity traps. Oh well; and he is on our side. As they say, with friends like this...