Keynes’ Liquidity Preference Trumps Debt Deflation in 1931 and 2008
by Philip Pilkington
I have pointed out before that the meaning of the term ‘liquidity trap’ has today become completely altered — with said alteration mainly coming from Paul Krugman’s bizarre redefinition which seems tied up with his idea about a natural rate of interest and the central bank being unable to hit this natural rate due to their coming up against the zero-lower bound.
In actual fact, a liquidity trap occurs when people rush out of assets and instead hold money. This leads to a fall in asset prices and high interest rates which then do not respond to central bank action. We encountered a liquidity trap proper very briefly in late-2008 but due to unprecedented central bank interventions we had exited this liquidity trap by early-2009.
In this post I want to spell out exactly why Keynes thought his liquidity trap idea so important. In order to understand this we must read his short paper The Consequences to the Banks of a Collapse of Money Values which he wrote in 1931 and which is included in his book Essays in Persuasion.
Before he discusses what he will later call a ‘liquidity trap’ Keynes briefly mentions the phenomenon that is now known as ‘debt deflation’. Here is what he says,
We are familiar with the idea that a change in the value of money can gravely upset the relative positions of those who possess claims to money and those who owe money. For, of course, a fall in prices, which is the same thing as a rise in the value of claims on money, means that real wealth is transferred from the debtor in favour of the creditor, so that a larger proportion of the real asset is represented by the claims of the depositor, and a smaller proportion belongs to the nominal owner of the asset who has borrowed in order to buy it. This, we all know, is one of the reasons why changes in prices are upsetting. (p93)
Keynes treats debt deflation as if it were a perfectly well-known phenomenon. Many today, however, attribute the ‘discovery’ of this theory to Irving Fisher’s 1933 paper The Debt Deflation Theory of Great Depressions. It is usually one step from there to claim that silly old Keynes ignored the implications of debt deflation.
None of this is true. Keynes is not only aware of the debt deflation theory in 1931 but he also suggests that everyone is aware of it. One can only guess from reading the above paragraph that the idea was floating around in the ether at the time and was being discussed by upset bankers and their publications. Fisher then likely picked up on this and turned it into a theory of the depression.
But Keynes thinks that the “familiar” debt deflation theory is an enormous distraction. In the above cited paper he continues,
But it is not to this familiar feature of falling prices that I wish to invite attention. It is to a further development which we can ordinarily afford to neglect but which leaps to importance when the change in the value of money is very large—when it exceeds a more or less determinate amount.
Modest fluctuations in the value of money, such as those which we have frequently experienced in the past, do not vitally concern the banks which have interposed their guarantee between the depositor and the debtor. For the banks allow beforehand for some measure of fluctuation in the value both of particular assets and of real assets in general, by requiring from the borrower what is conveniently called a “margin.” That is to say, they will only lend him money up to a certain proportion of the value of the asset which is the “security” offered by the borrower to the lender. Experience has led to the fixing of conventional percentages for the “margin” as being reasonably safe in all ordinary circumstances. The amount will, of course, vary in different cases within wide limits. But for marketable assets a “margin” of 20 per cent to 30 per cent is conventionally considered as adequate, and a “margin” of as much as 50 per cent as highly conservative. Thus provided the amount of the downward change in the money value of assets is well within these conventional figures, the direct interest of the banks is not excessive;—they owe money to their depositors on one side of their balance-sheet and are owed it on the other, and it is no vital concern of theirs just what the money is worth. (p93)
Keynes clearly understood the financial system better than Irving Fisher. He knew that while debt deflation could transfer wealth from borrowers to creditors — a point he reiterated in the General Theory — he did not think that this was a particularly important phenomenon when considering the fragility of the financial system. Rather he emphasised something which seemed to him altogether a more pressing issue.
But consider what happens when the downward change in the money value of assets within a brief period of time exceeds the amount of the conventional “margin” over a large part of the assets against which money has been borrowed. The horrible possibilities to the banks are immediately obvious. Fortunately, this is a very rare, indeed a unique event. For it had never occurred in the modern history of the world prior to the year 1931. There have been large upward movements in the money value of assets in those countries where inflation has proceeded to great lengths. But this, however disastrous in other ways, did nothing to jeopardise the position of the banks; for it increased the amount of their “margins.” There was a large downward movement in the slump of 1921, but that was from an exceptionally high level of values which had ruled for only a few months or weeks, so that only a small proportion of the banks’ loans had been based on such values and these values had not lasted long enough to be trusted. Never before has there been such a world-wide collapse over almost the whole field of the money values of real assets as we have experienced in the last two years. And, finally, during the last few months—so recently that the bankers themselves have, as yet, scarcely appreciated it—it has come to exceed in very many cases the amount of the conventional “margins.” In the language of the market the “margins” have run off. The exact details of this are not likely to come to the notice of the outsider until some special event—perhaps some almost accidental event—occurs which brings the situation to a dangerous head. For, so long as a bank is in a position to wait quietly for better times and to ignore meanwhile the fact that the security against many of its loans is no longer as good as it was when the loans were first made, nothing appears on the surface and there is no cause for panic. Nevertheless, even at this stage the underlying position is likely to have a very adverse effect on new business. For the banks, being aware that many of their advances are in fact “frozen” and involve a larger latent risk than they would voluntarily carry, become particularly anxious that the remainder of their assets should be as liquid and as free from risk as it is possible to make them. This reacts in all sorts of silent and unobserved ways on new enterprise. For it means that the banks are less willing than they would normally be to finance any project which may involve a lock-up of their resources. (p93-94)
Here is the liquidity trap proper. It occurs when asset values fall so far, so fast that markets then herd into liquid assets — that is, money or money substitutes — and begin to dump all the rest of their financial assets. The end result becomes a situation wherein falls in asset prices beget falls in asset prices and banks rush for money and other money substitutes. But, in classic Keynes fashion, what works for the individual does not work for everyone: when all the banks dump assets at the same time their money value drops so far that the banks themselves become insolvent.
In the discussion that follows Keynes makes crystal clear that he means basically all assets: he discusses commodity prices, stock prices, bond prices and housing prices. For him a liquidity trap occurs when money rushes out of all these asset classes and into money or money substitutes. The effect is a rising interest rate on bonds and a fall in prices on other assets.
This, of course, is precisely what we saw in 2008. But it is also what Keynes saw in 1931. The difference was that in 2008 we had a reaction from the central banks which printed massive amounts of money to prop up asset prices while in 1931 we saw extensive bank failures. Funnily enough, this policy is today associated with Milton Friedman and monetarism but it is clear that Keynes’ idea of the liquidity trap was highlighting the exact same problem.
Keynes’ liquidity trap is almost certainly a more important phenomenon than debt deflation. It is the decline in asset prices that has extensive effects on the financial sector, not the rise in the value of money per se. But that said, the liquidity trap phenomenon is not all that important with regards to shortfalls in aggregate demand.
In the other essays Keynes wrote at the beginning of the depression it is clear that while he thought the liquidity trap phenomenon precipitated the fall in confidence which led to a drying up of investment and a massive shortfall in aggregate demand, solving the liquidity trap problem and stabilising asset prices would not solve the aggregate demand problem. That is a lesson we have relearned today in the wake of 2008. Central bank interventions can certainly stabilise the financial markets — although some, like housing, respond far slower than others like bonds, the stock market or commodities — but only large increases in aggregate expenditure can reflate the economy.