Sunday, December 2, 2012

Is Rejection of the Liquidity Trap Doctrine an Act of Willful Blindness?

A number of posters write that this blog does not engage in any economic analysis, and while I might disagree with that claim, nonetheless this blog is not as analytical as some others, including Bob Murphy's Free Advice and Robert Wenzel's Economic Policy Journal, both of which are excellent blogs and well worth reading. (Both of them take on Paul Krugman and do it quite well. Murphy's latest devastating salvo is found here.)

Instead of going after Krugman's Monday NYT column, instead I want to deal -- using economic analysis -- with a recent Krugman blog post entitled: "Against Willful Denseness, The Gods Themselves Contend In Vain," in which he declares:
From the very beginning of the Lesser Depression, the central principle for understanding macroeconomic policy has been that everything is different when you’re in a liquidity trap. In particular, the whole case for fiscal stimulus and against austerity rests on the proposition that with interest rates up against the zero lower bound, the central bank can neither achieve full employment on its own nor offset the contractionary effect of spending cuts or tax hikes.

This isn’t hard, folks; it’s just Macro 101. Yet a large number of economists — never mind politicians or policy makers — seems to have a very hard time grasping this basic concept.
He adds:
We’re not talking about stupid people here; clearly, there’s something about the notion that the rules for policy depend on the situation that some economists just don’t want to understand.
In other words, Krugman has explained it, so it must be true, and anyone who might disagree with him either is hopelessly ignorant or, frankly, evil. There can be no honest disagreement, since to disagree with Krugman on this point is dishonest.

Understand, I am taking his words and, I believe, interpreting them fairly.This is what I learned in Logic 101 as the "appeal to authority," which here means that since the term "liquidity trap" is taught in macroeconomics, then there can be no argument against it, any more than one is permitted to claim that FDR's New Deal extended the Great Depression or that high tax rates just might squelch capital investment.

Moreover, just because Krugman appeals to the "liquidity trap" does not mean it is a legitimate economic concept. Murray N. Rothbard 50 years ago took on this doctrine and had a number of criticisms, writing:
The ultimate weapon in the Keynesian arsenal of explanations of depressions is the "liquidity trap." This is not precisely a critique of the Mises theory, but it is the last line of Keynesian defense of their own inflationary "cures" for depression. Keynesians claim that "liquidity preference" (demand for money) may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression. This statement assumes that the rate of interest is determined by "liquidity preference" instead of by time preference; and it also assumes again that the link between savings and investment is very tenuous indeed, only tentatively exerting itself through the rate of interest. But, on the contrary, it is not a question of saving and investment each being acted upon by the rate of interest; in fact, saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with this matter.
Furthermore, interest rates are not low because people's time preferences have changed and they are saving more. No, they are low because the Federal Reserve System has pushed them down to artificially-low levels, while at the same time, the Fed is trying to prop up malinvestments not only  here but also across the globe.

I would add the the "liquidity trap" doctrine also is based upon the economic fallacy that government essentially can do away with the Law of Scarcity by pushing down interest rates and by printing money. If one were to ask Krugman how this is possible, he would counter that there are "idle resources" (including lots of unemployed labor) that are sitting fallow because of a "lack of demand."

If one were to continue the questioning with, "What caused the 'lack of demand'?" he would answer, "Because people stopped spending." And if one asked, "Why did people stop spending," he most likely would answer, "Because of the financial crisis."

Yet, what caused the financial crisis? Malinvestments. That's right, malinvestments, those very things that Keynesians claim can be turned profitable with just a little more "stimulus" money, created the crisis in the first place. (Kind of like the housing market, which the government unsuccessfully has tried to reflate since its collapse in 2008.)

Now, that is interesting, given that malinvestment is an Austrian term, and Austrians are not supposed to know anything about economics. The idea behind "stimulus" and ratcheting up spending is that if the government spends enough money on lots of things, somehow those malinvested items will be resurrected and become profitable again. Now, why these things would supernaturally become profitable is another question, but Krugman and the Keynesians seem to believe that as long as the government is throwing money at something, sooner or later it will become a winner. (Krugman's insistence that massive government subsidies of "green energy" some day will magically transform that industry into something genuinely profitable is an example of the wishful thinking that accompanies Keynesianism.)

I also would add that the "liquidity trap" doctrine assumes that even though mutually-beneficial exchanges would be possible, individuals will act irrationally refuse to act on those opportunities. Why? "Because we are in a liquidity trap," and everyone knows that the liquidity trap overturns logic, the Law of Opportunity Cost, and probably the Law of Gravity.

My larger point is that Austrians really do have a basis for disagreeing with the Keynesian viewpoints, and the basis is grounded in logic and fundamental laws of economics. That Krugman interprets this disagreement as nothing more than yahoos wallowing in their willfulness says much more about Krugman than it does the Austrians.

18 comments:

Lord Keynes said...

"Malinvestments. That's right, malinvestments, those very things that Keynesians claim can be turned profitable with just a little more "stimulus" money, created the crisis in the first place. ...
The idea behind "stimulus" and ratcheting up spending is that if the government spends enough money on lots of things, somehow those malinvested items will be resurrected and become profitable again.
"


Not true. Keynes believed that asset price inflation is a deleterious and unsustainable process for any economy.

There are many Keynesians who think that housing prices must fall back to lower levels, roughly back to the historical real value.

As for capital goods projects that cannot earn a profit, they will go bankrupt if no one wants their products, even with Keynesian stimulus.

"My larger point is that Austrians really do have a basis for disagreeing with the Keynesian viewpoints, and the basis is grounded in logic and fundamental laws of economics."

And yet some of the Austrians you point to can't even agree on the "fundamental laws of economics". Take the pure time preference theory of interest rates.

You cite Robert Murphy. Yet anyone who has actually read his work knows that Murphy rejects the pure time preference theory of interest rates. He accepts - like an Keynesian - a monetary theory of interest rates.

http://socialdemocracy21stcentury.blogspot.com/2011/07/robert-p-murphy-on-pure-time-preference.html

Yet other Austrians like Hayek or Ludwig Lachmann accepted the idea of Keynesian stimulus in a deep depression, precisely because they accepted - like any Keynesian - that government stimulus can benefit an economy when a large volume of idle resources exist.

http://socialdemocracy21stcentury.blogspot.com/2011/09/did-hayek-advocate-public-works-in.html

http://socialdemocracy21stcentury.blogspot.com/2012/02/lachmann-endorsed-keynesian-stimulus-in.html

William L. Anderson said...

More examples of the fallacy of "appeal to authority."

Note that LK never did explain how we get to this "liquidity trap" in the first place. Keynesians have no causality in their "theories." Instead, things just "happen" and then government runs to the rescue by printing money.

Lord Keynes said...

"More examples of the fallacy of "appeal to authority."

There us no "appeal to authority" above. Since I do not believe Austrian economists are "authorities" on economics, I am hardly saying that my arguments are true, merely because some Austrians happen to agree on certain points.

Nor do I say my views are true merely because Keynes said so. My point is that Keynesians do not endorse asset price inflation, despite what Anderson says.

"Note that LK never did explain how we get to this "liquidity trap" in the first place."

Because the private sector is heavily indebted, many households and business are deleveraging, and we are experiencing, as Richard Koo says, a balance sheet recession crisis. The creation of mass excess reserves by the Fed does not induce necessary new investment, nor the imaginary hyperinflation predicted by hapless Austrians, when they are over-indebted and they have poor expectations owing to depressed demand.

And, no, the blame for that cannot be laid solely at the door of the Fed. The main culprit is the end of effective financial regulation that allowed private sector financial institutions to pump so much private debt into the economy that we had a bubble economy over the past 20 years, first stocks and shares (the Clinton boom) and then real estate (2000s boom).

For those who want an alternative viewpoint from the Austrian dogma of Anderson:

http://socialdemocracy21stcentury.blogspot.com/2012/05/richard-koo-on-wests-lost-decade.html

http://socialdemocracy21stcentury.blogspot.com/2011/11/steve-keen-on-hardtalk.html

http://socialdemocracy21stcentury.blogspot.com/2012/10/richard-koo-on-macroeconomics-and.html

http://socialdemocracy21stcentury.blogspot.com/2012/05/richard-koo-on-wests-lost-decade.html

http://socialdemocracy21stcentury.blogspot.com/2012/10/richard-koo-on-macroeconomics-and.html

http://socialdemocracy21stcentury.blogspot.com/2012/01/richard-koo-in-balance-sheet-recession.html

William L. Anderson said...

Interesting. Which part of "deregulation" caused the meltdown? Was the "Greenspan-Bernake Put" irrelevant? Are you saying that the government's numerous programs to bring about more home ownership had no effect?

Did the Fed's vast expansion of credit have anything to do with what happened? Or are you going to claim that markets are like the band in "Animal House" which tried vainly to march through a brick wall?

LK wants us to believe that prices are relevant ONLY when they are part of an index, and that no one ever responds to price signals and to profits and losses (except government regulators, of course).

I always love it when people wave the "deregulation" bloody shirt, but have no answer as to what specific aspect of deregulation caused the problem. It is just rhetoric and nothing else.

Lord Keynes said...

"Which part of "deregulation" caused the meltdown? "

First, I take it you don't dispute that financial deregulation has been an important element of economic policy over the past 30 years?

After all, you said this in 2001:

“the amount of economic regulation has fallen tremendously in the past three decades. In 1970, all the financial, transportation and telecommunications sectors were highly cartelized industries. All are much more open and competitive today. In fact, one can easily declare that the prosperity of the 1990s would not have been remotely possible without removal of government restrictions that hampered those industries in the 1960s.”

William L. Anderson, “The Party is Over,” Mises Daily, February 20, 2001.
http://mises.org/daily/617

Apart from the fact that the "prosperity" of the Clinton era was a hollow and unsustainable asset bubble boom (which never seems to have occurred to you when you wrote that post!! - perhaps you ought explain your error, huh?), you are correct that financial sector deregulation occurred from the late 1970s.

The important bills:

Depository Institutions Deregulation and
Monetary Control Act (1980)

Garn–St. Germain Depository Institutions Act (1982)

Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)

Financial Services Modernization Act of (1999), also called the Gramm-Leach-Bliley Act

Commodity Futures Modernization Act (2000).

The SEC’s Voluntary Regulation Regime for Investment Banks (2004)

-----
The Depository Institutions Deregulation and
Monetary Control Act (1980) and
Garn–St. Germain Depository Institutions Act (1982) were major contributors to the Savings and Loan crisis.

The last three were major causes of the surge in poor quality mortgage loans and the creation of CDOs.

The financial crisis was induced by the collapse in value of CDOs, including MBSs.

The private sector financial institutions pumped in so much private debt causing asset price inflation, and poor quality loans to people who should not have got them, because it was allowed to create a vast volume of such bad loans and then slice and dice them and load up on debt as part of the asset side of balance sheets.

"Did the Fed's vast expansion of credit have anything to do with what happened?

Indeed it did - but in the absence of effective financial sector regulation.

Nation after nation had very low rates and cheap money policies after the WWII, but the world was never hit but vast destabilising asset bubbles in that era or financial sector collapse, precisely because banks were regulated reasonably well back then. Of course, you have no answer to that because it refutes your Austrian school nonsense.

"LK wants us to believe that prices are relevant ONLY when they are part of an index, and that no one ever responds to price signals and to profits and losses"

False. Nothing but a straw man.

William L. Anderson said...

What we had during the Clinton years was a financial bubble, but standards of living still were higher because of the economic activity that occurred in the wake of deregulation of a number of sectors of the economy. It is not a one-or-the-other proposition, nor did I ever make that claim.

So, there was no such thing as Freddie and Fannie, and the government never put pressure on banks and real estate firms to give loans to people who probably did not qualify. Interesting. A number of people who actually are in that business have said the opposite.

You are correct in that the government had created a number of relatively small financial cartels post-New Deal. (The kind of regulation you endorse is quite good at creating cartels. Oh, I forgot. Keynesians believe cartels are bad. Except when the government creates them.)

Nonetheless, you still are saying that because of deregulation, banks and other financial entities somehow were unable to respond to real price signals. Please explain how deregulation would do that.

Or, maybe the Greenspan-Bernanke "Put" might have had something to do with these people ignoring price signals.

Bala said...

O Genius,

Care to explain the causality in this?

"The last three were major causes of the surge in poor quality mortgage loans and the creation of CDOs."

William L. Anderson said...

Please define "poor quality mortgage loans." And many of the CDOs were created by Freddie and Fannie which essentially are arms of the government.

Anonymous said...

This has always bugged me about the "government induced loans" explanation of the crisis: If the government put pressure on the banks to provide loans at below market rates or for people who would not qualify (in effect, a price control), shouldn't the effect on the market be a shortage as opposed to an oversupply?

If my logic isn't wrong (and,alas, it probably is) and in the end there were other government mandated forces that inverted this tendency and contributed to the explosion of cheap credit, then aren't references to the CRA and similar policies irrelevant distractions?

William L. Anderson said...

As Peter Schiff so aptly put it, Wall Street got stinking drunk, but it was the Fed filling the punchbowl and providing the booze.

Yes, I think that if we are going to have deregulation, then we also need to eliminate the moral hazard that the Fed provides. We cannot have both.

In the pre-1980s banking environment, you did not see speculative bubbles, but you also did not have the capability of financing a lot of the new technological initiatives that came along in the 1970s and 80s. The old regulated cartel simply could not deal with entrepreneurship and innovation.

By the way, the deregulation bills that LK listed earlier really should have been classified as Re-regulation. Furthermore, these laws gave the Fed even more power and influence and helped to further the sorry institution of Crony Capitalism.

Mike said...

“Yes, I think that if we are going to have deregulation, then we also need to eliminate the moral hazard that the Fed provides. We cannot have both.”

That right there cuts to the core of the issue! Superimpose on that a proper application of rule of law and enforcement that protects individuals and property and you create the best opportunity for a functional capitalist structure.

The trouble with LK’s “analysis” is some of the elements of what he says is correct, but is never willing to peel the onion further to answer the How and Why. For example:

“The private sector financial institutions pumped in so much private debt causing asset price inflation,…”
And who supplied the credit? Or in Schiff’s term the punch?

Or

“…precisely because banks were regulated reasonably well back then. Of course, you have no answer to that because it refutes your Austrian school nonsense.”

The only nonsense is LK’s interpretation. I’m unaware of any Austrian school that advocates or defends fraud and corruption or moral hazard of supplying the financial sector with risk free endless credit backed by the citizen.

Tel said...

When Krugman says, "Macro 101" what he means is "Keynesian Macro 101" on the basis that he only accepts that one school of Economics can possibly exist.

In order to make a viable theory, Krugman would need solid definitions for both exactly how to detect a "liquidity trap" and also exactly what "full employment" means. He provides neither.

Of course very low interest rates on short-term treasury bills are a matter of Fed policy, so if you take this as your metric for a "liquidity trap" then the logical implication is that we are in a liquidity trap any time Fed policy says we are. Presumably then the Fed can create the "everything is different" effect at will, because they say so.

More sensibly, we could look at some other interest rates, for example the 30 year FRM rate (something that directly applies to real people).

http://mortgage-x.com/images/graph/r_arm_frm.gif

Not only is it not at zero, but we see an almost linear declining trend from 1984 to today. Krugman started calling "liquidity trap" somewhere around 2009, so the 30 year FRM was at approx 5% at the time and since then has continued to drop to approx 3.5% so we would have to guess that there are still a few years of this trend before we hit zero, but maybe the key threshold cuts in at 5% instead of zero? Only Krugman can explain it.

Can interest rates drop during the middle of a liquidity trap? It would seem that yes they can continue to drop.

Bob Roddis said...

1. Lord "Rain Man" Keynes still does not understand the concept of economic calculation.

2. The "liquidity trap" (what a garbage concept) occurs when people wake up and find themselves in a situation where they see it is pointless to speculate on asset values using borrowed funny money because prices are falling or un-inflatable due to prior malinvestments which are now collapsing and they need to wait out the collapse. Keynesians cannot or will not understand any of this analysis because they cannot or will not understand the self-evident concept of economic calculation. The concept is like Kryptonite to the tiny mind of a Keynesian who can sense that the concept of economic calculation destroys the entirety of the Keynesian Hoax. As such, it must be ignored, suppressed, misrepresented or mocked.

Dinero said...

If a buisiness man will not take a loan at zero interest rate to use for pojects then that is the Liquidity Trap. At zero rate there is still a little something the Central Bank could do and that is to make a commitment to holding the interest rate at zero for the duration of the loan.

fresno dan said...

Interesting points.
I would merely add that the elephant in the room is credit availability as opposed to interest rate. Note the distinction between credit availability and price of credit.
Loose credit inflates prices. Tight credit deflates (or perhaps more accurately restores prices to a price THAT CAN BE PAID in reality - the borrower has the funds to pay the loan back).

Things get mispriced. Sometimes quite a few, for quite a long period. Somebody has to take the losses. In democracies, people want the "government" to do it. The government can only disguise who is getting screwed.

Bob Roddis said...

The entire garbage term "liquidity trap" assumes that "monetary policy" is something that can be purposefully employed for a positive good and that it "stops working" during the post boom bust when artificial prices are collapsing. It is true that it no longer works during the "liquidity trap" to entice people to borrow money for malinvestments, but that is a good thing.

Tel said...

Dinero: "If a buisiness man will not take a loan at zero interest rate to use for pojects then that is the Liquidity Trap."

I'm happy to accept that as a definition, but the conclusion is we are NOT in a liquidity trap because plenty of small business out there does NOT have access to zero interest loans. That's the trick of the whole central bank system -- free money available to some but not to others.

Krugman would be well aware of this.

Dinero said...

The Fed Reserve has a 1970 remit including “ "to promote effectively the goals of maximum employment,” and so the word trap is being used when it has run out of tools with which to carry out its remit. Although the particular word “trap” it is still an unnecessary jargon.

It can be argued that maximum employment has nothing to do with providing a nations money and there the the argument is with the Fed’s remit. For example - It is not a fundamental characteristic of a central bank , The Bank of England does not have that remit.