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Paul Krugman discusses the origins of the term "liquidity trap" this weekend noting that he didn't invent the term. This is interesting to me as I read Thomas Piketty's Capital because I've found myself going back to the General Theory at times while thinking of various subjects. Keynes, of course, was the originator of the concept of the "liquidity trap", but he used the term in a manner that I do not believe is consistent with the way Krugman and the New Keynesians use the term. In the General Theory, Keynes discussed the liquidity trap saying:

"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."

And here's how Krugman defines the "liquidity trap":

"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."

These sound similar, but they are not the same thing. Keynes is describing a situation in which the Central Bank has lost control of interest rates and therefore has lost the ability to influence the price of other assets in the economy. That's clearly not the environment we are currently in. You could argue, for a brief period in 2008, that this was definitely what happened in the USA as corporate bonds were collapsing, the TED Spread was blowing out and the Fed appeared totally behind the curve. This was short-lived though and the Fed regained control of interest rates very quickly after QE was initiated in late 2008.

I've previously argued that, if the legal constraints on U.S. monetary policy were different, that the Fed could perform something more closely resembling a helicopter drop (as opposed to asset swaps via QE). This would essentially resemble fiscal policy as it would add net financial assets to the private sector. Also, it's clear that one of the primary transmission mechanisms of monetary policy has been hurt because the demand for debt is low and lowering interest rates has been a blunt instrument for increasing demand for loans (and also, we know that banks don't "lend out" reserves as Krugman has previously asserted), but that hardly means that all of the Fed's transmission mechanisms are broken or that they've "lost effective control over the rate of interest".

In other words, monetary policy isn't ineffective in this environment because of the liquidity trap. It's ineffective because the demand for debt is abnormally low and the way the Fed is currently implementing policy is either not creative enough (like, for instance, setting a target rate on 30 year U.S. government bonds) or it is legally constrained by what the Fed can purchase (the Fed can't purchase "Roche's Bags-O-Dirt" in effect purchasing worthless non-financial assets for a net financial asset).

So, I don't know if Keynes would have called this a "liquidity trap". He certainly would have described it as an odd economic environment (possibly a "secular stagnation" resulting from other macroeconomic effects such as Piketty's inequality) and one where monetary policy is less effective than it is outside of a de-leveraging, but I am highly skeptical that he would have agreed with the way the term "liquidity trap" is being used by Dr. Krugman and the New Keynesians.

Source: Would Keynes Have Called This A 'Liquidity Trap'?