I intend this to be a two part series: the first will outline some recent commentary on liquidity traps and how taken together, the signify a larger shift in thinking. And in the second I hope to outline some…less popular theories in monetary economics and how they relate to stabilization policy.
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I have to admit that I came to economics through a fairly unorthodox channel. The first economics book I ever read (and the book that sparked my interest in the field) was Silvio Gesell’s The Natural Economic Order. Being inexperienced, I had simply taken for granted that this book was one of those “classics” in economics, like David Ricardo’s On the Principles of Political Economy and Taxation, or John Maynard Keynes’ General Theory of Employment, Interest, and Money. Imagine my surprise to find out that few professional economists have heard of Gesell’s monetary theories, even fewer talk about them, and literally zero teach about them. I was an instant heterdox.
However, the more I’ve thought about the recent recession, the more I keep coming back to the money system. One very pernicious concept that keeps recurring in popular economics literature and discourse is, of course, the ubiquitous “liquidity trap“. Many of you have no doubt noticed that I always refer to the concept in quotations on my blog. This is because I find it untenable for two reasons:
- It is not at all clear that “liquidity traps” naturally occur in the real world.
- There are so many theoretical escapes from the “liquidity trap” as to render the concept completely useless.
Even the most famous of old-style Keynesians recognizes (recognized?) that the entire concept is rather dubious and in an attempt to rescue the theory, outlined a much more accurate model of expectations traps…which, incidentally, is nothing like a “liquidity trap”. The implications of which are that monetary policy, when targeting a nominal variable, can be highly effective at the zero lower bound. Scott Sumner has become a famous figure in the monetary/macro blogosphere for his analysis of monetary policy during the crisis — and he doesn’t look too kindly upon the concepts of “liquidity traps” either. And of course, I was pleasantly surprised to find Greg Mankiw publicly speaking of Gesell’s monetary theories in a positive manner. So pleasantly surprised, in fact, that I was compelled to e-mail him this link regarding the effect of the real-world application of negative interest on the medium of exchange (he never responded, if you were wondering).
There have been three recent developments that have been very heartening for us “liquidity trap skeptics”.
- The first was the Fed’s announcement that the Fed will be using the interest rate paid on reserves as the instrument of policy.
Why is this such a big deal? The fundamental problem of all deep recessions in history(?) has been a mismatch between the supply of-, and the demand to hold the medium of exchange. Because everyone accepts the concept of what we call money as payment for goods and services, and because it has the Federal government behind it: cash is a “zero-risk” asset. When problems in the real (or financial in this case) economy appear, they drive people to take less risk (identified as ‘animal spirits’ by Keynes…mostly because he didn’t understand what was going on), and thus people demand to hold cash (or near-cash liquid assets: government bonds) on their balance sheets. This causes a fall in velocity. The problem that has plagued numerous economies throughout history has been that the supply of money is never adequate to accommodate this increased demand quickly enough. Thus, monetary disequilibrium. Absent a correction mechanism, nominal wages and prices must fall to bring the supply and demand for money into alignment. However, since wages and prices are sticky, the interim is filled with economic malaise like falling investment, and unemployment.
The interest rate on excess reserves is an administered rate. This means that there is nothing natural about it, and it needn’t correspond with any other interest rate — it is completely decided by fiat…and more importantly, it is binding and it can be negative. This allows the Federal Reserve a very powerful monetary tool in stabilization policy: control over excess reserve balances. In theory, the Fed can pay whatever is needed to persuade banks to hold these reserves in boom times — indeed, it is risk-free investment. A few may get out here and there, but as long as the Fed is targeting some nominal variable, it can stabilize these “rogue reserves” fairly easily. Upon the onset of recession, the Fed can then persuade banks to loan these reserves (overnight?) through interest penalties.
- Then, we have a couple rather notable leftist-liberal political economics writers beginning to doubt the concept. Here’s Ryan Avent at The Economist:
I am increasingly convinced that it is the commitment of a central bank to continue stimulating that is important, rather than the room that central banker has to cut rates. The determined central banker doesn’t blink at 0%, he or she simply switches policy tools. And if this is right, then perpetuation of zero lower bound idea simply provides cover to central bankers who aren’t willing to continue easing. That’s a decision which should be justified on policy grounds, not chalked up to some imagined constraint.
- Finally (and this is the smoking gun that makes me smile), our “famous Keynesian” from earlier, who has since reverted back to his crude ways of thinking (which includes “binding liquidity traps”), actually admits that the implication of the “liquidity trap” is…
Why don’t people get this? Part of the answer is that it’s really hard for non-economists — and many economists, too! — to wrap their minds around the Alice-through-the-looking-glass nature of economics when you’re in a liquidity trap.
This isn’t “part of the answer”. It’s rationalization for an economic model that doesn’t describe things that happen in reality. A last-ditch effort to rescue a pet theory. Just like Republicans and their vulgar conceptions of the “Laffer curve“, or RBC theorists and frictionless markets without nominal shocks.
As Scott Sumner would say, the zeitgeist is in the air! However, I want opinion to drift even further, and begin questioning why we believe our current monetary arrangements are optimal…and if they aren’t, why they persist.