Thursday, December 17, 2009

The “liquidity trap” is bunk, cr*p and drivel all rolled into one.

The New Palgrave Dictionary of Economics starts its definition of the liquidity trap as “A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective.”

Wikipidia’s definition is not much different. It starts thus. “The term liquidity trap is used in Keynesian economics to refer to a situation where the demand for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Therefore, if the economy enters a liquidity trap area -- and further increases in the money stock will fail to further lower interest rates -- monetary policy will be unable to stimulate the economy.”

This is all nonsense on stilts. It is clap trap. Do advocates of the liquidity trap seriously think that if every household in the country was given £10,000 in cash there’d be no effect? What do people do when they win a lottery? The average mentally retarded three year old knows the answer that: lottery winners SPEND their winnings (or a sizeable chunk of it). Bryan Caplan makes a similar point here.

So why are many economists incapable of solving a problem that the average mentally retarded three year old can solve? The answer is probably that economists have an interest in NOT solving economic problems. That is, solve an economic problem, and there will be fewer jobs for economists. At the very least, academic economists have an interest in exuding hot air, drivel and waffle: holding on to one’s job as a professional economist requires publishing a certain amount of material per year, even if one has nothing useful to say.

The theologians in the middle ages who argued about how many angels could dance on a pinhead (rather than solve the real problems facing the world they lived in) were similarly motivated. That is, for theologians in the middle ages, arguing about angels and pin heads kept them in food, wine, and shelter.

By way of keeping the debate on the liquidity trap going, economists often point to the fact that Japan greatly increased its money supply in the 1990s to little effect. Well of course there wasn’t much effect: this money supply increase was done via quantitative easing. That is Japan’s central bank gave people cash in exchange for the latter’s bonds. Well what’s the big difference between cash and bonds? Not much. They are both fairly liquid forms of saving. That’s why there was little effect.

Increasing the money supply and giving it all to people who are determined to put it on their compost heap and rot it down into compost will have no effect. But to argue from this that ALL money supply increases have no effect, is clearly nonsense. At least for mentally retarded three year olds, the nonsense is clear enough.

Finally, it should be said that some definitions of the liquidity trap consist of the idea that recessions can persist despite interest rates being zero – in which case fiscal policies are required. That is, some advocates of the liquidity trap are arguably well aware of the fact that printing enough money and dishing it out to households will solve the problem. But I suspect that many of the aforementioned advocates are not aware of this point.

Afterthought (25th Nov. 2010): Nice to see Scott Sumner agreeing.

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