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The fiction of a liquidity trap

The fiction of a liquidity trap
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First Published: Tue, Jan 06 2009. 09 07 PM IST

Jim Young / Reuters
Jim Young / Reuters
Updated: Tue, Jan 06 2009. 09 07 PM IST
In the current climate of global economic uncertainty, central bankers are creating vast amounts of paper money from thin air to pump into the global economy. They cite a need to ward off dreaded effects of a “liquidity trap” that would make monetary policy totally ineffective.
Jim Young / Reuters
But the notion of a liquidity trap, as contrived by economist John Maynard Keynes, has a dubious history. What is being missed is that this condition is itself the outcome of irresponsible monetary policies that made financial sectors deeply dysfunctional. In this sense, central bankers are perpetrating and perpetuating the problems they claim to be seeking to avoid.
A liquidity trap supposedly occurs when very low interest rates induce an extreme “liquidity preference” in that investors shun bonds to avoid capital losses as interest rates eventually rise. This high demand for money balances neutralizes the capacity of monetary pumping to stimulate an economy.
This occurs since the choice to hold a large portion of wealth as cash balances will mean the rate of interest can never be low enough to stimulate investment spending. Since interest rates will not react to increases in the money supply, economic growth is unaffected by monetary pumping as new injections are hoarded and not spent.
The proposed cure is for central banks to conjure up newly printed money to buy up bad loans in the banking system and overvalued assets of corporations. The flood of paper money leads to negative real interest rates as prices rise rapidly so that aggregate demand rises. While negative real interest rates discourage saving and lower borrowing costs, inflation encourages people to buy more today to avoid higher prices tomorrow.
It turns out that the conceptualization of the liquidity trap (inadvertently?) reverses Keynes’ own explanation of the determinants of the interest rate.
In Keynes’ formulation, interest rates are determined by liquidity preference and the supply of money. However, when speaking of the liquidity trap, he specifies that the demand to hold money responds inversely to changes in the rate of interest.
But the liquidity trap requires that the demand for holding money is inversely related to the rate of interest. This implies that interest rates should peak during a depression and be minimal during a boom in the business cycle. In the current setting, interest rates in the US and Japan should be much higher than their present low levels at near zero.
In the end, the idea of holding cash balances is confused with savings that Keynes and his followers believe will reduce investment by reducing consumption spending. In other words, investment depends more upon spending rather than upon increased savings.
Few theorists would be bold enough to formulate an inconsistent expression depicting dual directions of causation. For his part, Keynes assumes the demand for cash determines the rate of interest while also assuming the rate of interest is determined by the demand for cash.
As a modern proponent of the liquidity trap, Paul Krugman is as confused and confusing as Keynes. Krugman suggests that an economy caught in a liquidity trap will slide into deflation. But he then states that deflation can push an economy into a liquidity trap. Like Keynes, he seems to like to have it both ways.
Urging central banks to create inflationary expectations by flooding an economy with money is fundamentally irresponsible. By causing them to misread capital costs relative to future demand, artificially cheap credit causes entrepreneurs to waste capital and savings.
A central bank can flood an economy with paper money but this cannot increase the productive capacity of an economy. Were this possible, every country could become prosperous by running printing presses.
Forcing interest below market rates causes harmful distortions in the structure of production as excessive credit formation induces firms to invest in unprofitable or unsustainable projects. One certain economic reality is that only a rise in savings induced by increased productivity can permanently bring down long-term interest rates.
Economic booms based on “cheap money” cause clusters of errors and misguided investments that eventually lead to profit squeezes as firms find that returns do not cover rising costs. Eventually, unemployment rises and idle capital begins to appear as consumers seek to restore their desired savings-consumption ratio.
Logical inconsistencies and the lack of historical evidence behind the notion of liquidity traps make them as detached from reality as Elvis sightings. Unlike imagined stirrings of a faded pop star that do little material harm, belief in economic mythologies can have disastrous consequences.
By setting absurdly low interest rates, central bankers set the stage for an inflationary credit boom to be followed by higher interest rates or hyperinflation that will lead to another bust. As banks release the massive reserves that exist in the banking system, new spending will occur without any increase in production, which will lead to price spikes.
This will require a reversal of easy-credit policies with higher interest rates and a withdrawal of liquidity that will bring the boom. And then, central bankers will find us in a similar situation, wondering how we got there and not knowing how to get us out.
Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and a visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Your comments are welcome at theirview@livemint.com
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First Published: Tue, Jan 06 2009. 09 07 PM IST