In his New York Times
article of January 11, 2012, the Nobel laureate Paul Krugman
wrote,
If nothing else, we've learned that
the liquidity trap is neither a figment of our imaginations nor something
that only happens in Japan; it's a very real threat, and if and when it ends
we should nonetheless be guarding against its return — which means that
there's a very strong case both for a higher inflation target, and for
aggressive policy when unemployment is high at low inflation.
The bottom line is that the Fed
almost surely won't, and very surely shouldn't, start raising interest rates
any time soon.
But does it make sense that by means
of more inflation the US economy could be pulled out of the liquidity trap?
The Origin of
the Liquidity-Trap Concept
In the popular framework of
thinking that originates from the writings of John Maynard Keynes, economic
activity is presented in terms of a circular flow of money. Thus, spending by
one individual becomes part of the earnings of another individual, and
spending by another individual becomes part of the first individual's
earnings.
Recessions, according to Keynes,
are a response to the fact that consumers — for some psychological
reasons — have decided to cut down on their expenditure and raise their
savings.
For instance, if for some reason
people have become less confident about the future, they will cut back on
their outlays and hoard more money. So, once an individual spends less, this
worsens the situation of some other individual, who in turn also cuts his
spending.
Consequently, a vicious circle sets
in: the decline in people's confidence causes them to spend less and to hoard
more money, and this lowers economic activity further, thereby causing people
to hoard more, etc.
Following this logic, in order to
prevent a recession from getting out of hand, the central bank must lift the
money supply and aggressively lower interest rates.
Once consumers have more money in
their pockets, their confidence will increase, and they will start spending
again, thereby reestablishing the circular flow of money, so it is held.
In his writings, however, Keynes suggested
that a situation could emerge when an aggressive lowering of interest rates
by the central bank would bring rates to a level from which they would not
fall further.
This, according to Keynes, could
occur because people might adopt a view that interest rates have bottomed out
and that rates should subsequently rise, leading to capital losses on bond
holdings. As a result, people's demand for money will become extremely high,
implying that people would hoard money and refuse to spend it no matter how
much the central bank tries to expand the money supply.
Keynes wrote,
There is the possibility, for the
reasons discussed above, 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. [1]
Keynes suggested that, once a
low-interest-rate policy becomes ineffective, authorities should step in and
spend. The spending can be on all sorts of projects — what matters here
is that a lot of money must be pumped, which is expected to boost consumers'
confidence. With a higher level of confidence, consumers will lower their
savings and raise their expenditure, thereby reestablishing the circular flow
of money.
Do Individuals
Save Money?
In the Keynesian framework the
ever-expanding monetary flow is the key to economic prosperity. What drives
economic growth is monetary expenditure. When people spend more of their
money, this is seen that they save less.
Conversely, when people reduce
their monetary spending in the Keynesian framework, this is viewed that they
save more. Observe that in the popular — i.e., Keynesian — way of
thinking, savings is bad news for the economy: the more people save, the
worse things become. (The liquidity trap comes from too much saving and the
lack of spending, so it is held.)
Now, contrary to popular thinking,
individuals don't save money as such. The chief role of money is as a medium
of exchange. Also, note that people don't pay with money but rather with
goods and services that they have produced.
For instance, a baker pays for
shoes by means of the bread he produced, while the shoemaker pays for the
bread by means of the shoes he made. When the baker exchanges his money for
shoes, he has already paid for the shoes, so to speak, with the bread that he
produced prior to this exchange. Again, money is just employed to exchange
goods and services.
To suggest then that people could
have an unlimited demand for money (hoarding money) that supposedly leads to
a liquidity trap, as popular thinking has it, would imply that no one would
be exchanging goods.
Obviously, this is not a realistic
proposition, given the fact that people require goods to support their lives
and well-being. (Please note: people demand money not to accumulate
indefinitely but to employ in exchange at some more or less definite point in
the future).
Being the medium of exchange, money
can only assist in exchanging the goods of one producer for the goods of
another producer. The state of the demand for money cannot alter the amount
of goods produced, that is, it cannot alter the so-called real economic
growth. Likewise a change in the supply of money doesn't have any power to
grow the real economy.
Contrary to popular thinking we
suggest that a liquidity trap does not emerge in response to consumers'
massive increases in the demand for money but comes as a result of very loose
monetary policies, which inflict severe damage to the pool of real savings.
Liquidity Trap
and the Shrinking Pool of Real Savings
As long as the rate of growth of
the pool of real savings stays positive, this can continue to sustain
productive and nonproductive activities. Trouble erupts, however, when, on
account of loose monetary and fiscal policies, a structure of production
emerges that ties up much more consumer goods than
the amount it releases. This excessive consumption relative to the production
of consumer goods leads to a decline in the pool of real savings.
This in turn weakens the support
for economic activities, resulting in the economy plunging into a slump. (The
shrinking pool of real savings exposes the commonly accepted fallacy that the
loose monetary policy of the central bank can grow the economy.)
Needless to say, once the economy
falls into a recession because of a falling pool of real saving, any
government or central-bank attempts to revive the economy must fail.
Not only will these attempts not
revive the economy; they will deplete the pool of real savings further,
thereby prolonging the economic slump.
Likewise any policy that forces banks
to expand lending "out of thin air" will further damage the pool
and will reduce further banks' ability to lend.
The essence of lending is real
savings and not money as such. It is real savings that imposes restrictions
on banks' ability to lend. (Money is just the medium of exchange, which
facilitates real savings.)
Note that without an expanding pool
of real savings any expansion of bank lending is going to lift banks'
nonperforming assets.
Contrary to Krugman,
we suggest that the US economy is trapped, not because of a sharp increase in
the demand for money, but because loose monetary policies have depleted the
pool of real savings. What is required to fix the economy is not to generate
more inflation but the exact opposite. Setting a higher inflation target, as
suggested by Krugman, will only weaken the pool of
real savings further and will guarantee that the economy will stay in a
depressed state for a prolonged time.
Notes
[1] John Maynard
Keynes, The General Theory of
Employment, Interest, and Money, MacMillan & Co. Ltd. (1964), p.
207.
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