Paul Krugman Does Not Understand the Liquidity Trap

Fixing the Economists Article of the Week

by Philip Pilkington

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. Our typical mainstream economist said:

“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.”

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.