Hypothetical Criticism

I have gotten absolutely zero criticism for my “Liquidity Traps are for Suckers” post. So instead of responding to actual criticism, I’m going to respond to a hypothetical criticism that I imagine that I would receive from someone like Paul Krugman if I were a more famous economist.

I can imagine that Krugman would point to Japan in the 90’s, and the entire world in the 30’s as “real world” examples of liquidity traps happening. Indeed, Krugman opines that 70% of the world is currently engaged in this sort of mystical thinking. Tyler Cowen thinks the number is actually zero percent. I think it’s safe to assume that Scott Sumner tips the scales in Cowen’s favor.

How does one get a disparity from zero to seventy? Especially among academic economists? Well, because the theory is garbage.

That is not to say that the condition of trading one zero-interest/zero-risk asset (cash) for another (bonds) doesn’t happen in the real world. Evidence from the recent recession would suggest that it absolutely does…however, it doesn’t represent a failure of monetary policy to retain effectiveness, nor does it change the fundamental tenants of basic economics in a way in which you can say literally anything you want, and assume it’s true. There is so little evidence for upward-sloping demand curves, even during “liquidity traps”, that analysis of this type should be placed in the zombie category (not to be confused with John Quiggin’s theory…or maybe it should. It certainly fits with his criteria).

I’d like to use a metaphor to describe what I think of when I think of a “liquidity trap”. Say you’re wandering down a single, narrow road, and come to a fork in which the road splits in two. A tough decision by any measure! Now say that you have to pay a troll to continue down one path, or climb a steep wall to continue down the other. Would you say that you are trapped? Or just severely inconvenienced (liquidity inconvenience?)? Instead of choosing either road, you decide to keep walking straight…into the tree holding the sign indicating “fork in the road”, and simply keep trying to walk through the tree. That is the fantastical equivalent of “being in” a “liquidity trap”. You clearly have other options, but decide to give up anyway. Eventually, with time, or someone else’s help, you’ll get around that tree…but it’s only your stupidity that is keeping you from continuing on your journey.

I don’t think Paul Krugman actually “believes” in liquidity traps. I think it’s just convenient for him to fall back into the General Theory, and say all kinds of things that happen to suit his political disposition. However, Krugman is fond of making up excuses (which can be more or less correct, but still amount to excuses) for failures in other parts of the political economy that “put is into a liquidity trap”…but I think that’s lazy.

Hope that cleared some stuff up!

Addendum: If John…someone…had never made the casual observation of liquidity preference in The General Theory, would we be throwing up our hands today, giving up and turning to massive deficit spending today? Or would we have alternate currency systems by now, which address the problems created by extreme liquidity preference? Would we have better monetary theory?


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