In earlier posts in my series about Hawtrey and Keynes, I’ve mentioned the close connection between Hawtrey’s concept of a “credit deadlock” and the better-known Keynesian concept of a “liquidity trap,” a term actually coined by J. R. Hicks in his classic paper summarizing the Keynesian system by way of the IS-LM model. As I’ve previously noted, the two concepts, though similar, are not identical, a characteristic of much of their work on money and business cycles. Their ideas, often very similar, almost always differ in some important way, often leading to sharply different policy implications. Keynes recognized the similarities in their thinking, acknowledging his intellectual debt to Hawtrey several times, but, on occasion, Keynes could not contain his frustration and exasperation with what he felt was Hawtrey’s obstinate refusal to see what he was driving at.
In this post, commenter GDF asked me about the credit deadlock and the liquidity trap:
Would you mind explaining your thoughts apropos of differences between Hawtrey’s credit deadlock theory and Keynes’ liquidity trap. It seems to me that modern liquidity trapists like Krugman, Woodford etc. have more in common with Hawtrey than Keynes in the sense that they deal with low money demand elasticity w.r.t. the short rate rather than high money demand elasticity w.r.t. the long rate.
To which I answered:
My view is that credit deadlock refers to a situation of extreme entrepreneurial pessimism, which I would associate with negative real rates of interest. Keynes’s liquidity trap occurs at positive real rates of interest (not the zero lower bound) because bear bond speculators will not allow the long-term rate to fall below some lower threshold because of the risk of suffering a capital loss on long-term bonds once the interest rate rises. Hawtrey did not think much of this argument.
Subsequently in this post, commenter Rob Rawlings suggested that I write about the credit deadlock and provided a link to a draft of a paper by Roger Sandilands, “Hawtreyan ‘Credit Deadlock’ or Keynesian ‘Liquidity Trap’? Lessons for Japan from the Great Depression” (eventually published as the final chapter in the volume David Laidler’s Contributions to Economics, edited by Robert Leeson, an outstanding collection of papers celebrating one of the greatest economists of our time). In our recent exchange of emails about Hawtrey, Laidler also drew my attention to Sandilands’s paper.
Sandilands’s paper covers an extremely wide range of topics in both the history of economics (mainly about Hawtrey and especially the largely forgotten Laughlin Currie), the history of the Great Depression, and the chronic Japanese deflation and slowdown since the early 1990s. But for this post, the relevant point from Sandilands’s paper is the lengthy quotation with which he concludes from Laidler’s paper, “Woodford and Wicksell on Interest and Prices: The Place of the Pure Credit Economy in the Theory of Monetary Policy.”
To begin with, a “liquidity trap” is a state of affairs in which the demnd for money becomes perfectly elastic with respect to a long rate of interest at some low positive level of the latter. Until the policy of “quantitative easing” was begun in 2001, the ratio of the Japanese money stock to national income, whether money was measured by the base, M1, or any broader aggregate, rose slowly at best, and it was short, not long, rates of interest that were essentially zero. Given these facts, it is hard to see what the empirical basis for the diagnosis of a liquidity trap could have been. On the other hand, and again before 2001, the empirical evidence gave no reason to reject the hypothesis that a quite separate and distinct phenomenon was at work, namely a Hawtreyan “credit deadlock”. Here the problem is not a high elasticity of the economy’s demand for money with respect to the long rate of interest, but a low elasticity of its demand for bank credit with respect to the short rate, which inhibits the borrowing that is a necessary prerequisite for money creation. The solution to a credit deadlock, as Hawtrey pointed out, is vigorous open market operations to bring about increases in the monetary base, and therefore the supply of chequable deposits, that mere manipulation of short term interest rates is usually sufficient to accomplish in less depressed times.
Now the conditions for a liquidity trap might indeed have existed in Japan in the 1990s. Until the credit deadlock affecting its monetary system was broken by quantitative easing in 2001 . . . it was impossible to know this. As it has happened, however, the subsequent vigorous up-turn of the Japanese economy that began in 2002 and is still proceeding is beginning to suggest that there was no liquidity trap at work in that economy. If further evidence bears out this conclusion, a serious policy error was made in the 1990s, and that error was based on a theory of monetary policy that treats the short interest rate as the central bank’s only tool, and characterizes the transmission mechanism as working solely through the influence of interest rates on aggregate demand.
That theory provided no means for Japanese policy makers to distinguish between a liquidity trap, which is a possible feature of the demand for money function, and a credit deadlock which is a characteristic of the money supply process, or for them to entertain the possibility that variations in the money supply might affect aggregate demand by channels over and above any effect on market rates of interest. It was therefore a dangerously defective guide to the conduct of monetary policy in Japan, as it is in any depressed economy.
Laidler is making two important points in this quotation. First, he is distinguishing, a bit more fully than I did in my reply above to GDF, between a credit deadlock and a liquidity trap. The liquidity trap is a property of the demand for money, premised on an empirical hypothesis of Keynes about the existence of bear speculators (afraid of taking capital losses once the long-term rate rises to its normal level) willing to hold unlimited amounts of money rather than long-term bonds, once long-term rates approach some low, but positive, level. But under Keynes’s analysis, there would be no reason why the banking system would not supply the amount of money demanded by bear speculators. In Hawtrey’s credit deadlock, however, the problem is not that the demand to hold money becomes perfectly elastic when the long-term rate reaches some low level, but that, because entrepreneurial expectations are so pessimistic, banks cannot find borrowers to lend to, even if short-term rates fall to zero. Keynes and Hawtrey were positing different causal mechanisms, Keynes focusing on the demand to hold money, Hawtrey on the supply of bank money. (I would note parenthetically that Laidler is leaving out an important distinction between the zero rate at which the central bank is lending to banks and the positive rate — sufficient to cover intermediation costs – at which banks will lend to their customers. The lack of borrowing at the zero lower bound is at least partly a reflection of a disintermediation process that occurs when there is insufficient loan demand to make intermediation by commercial banks profitable.)
Laidler’s second point is an empirical judgment about the Japanese experience in the 1990s and early 2000s. He argues that the relative success of quantitative easing in Japan in the early 2000s shows that Japan was suffering not from a liquidity trap, but from a credit deadlock. That quantitative easing succeeded in Japan after years of stagnation and slow monetary growth suggests to Laidler that the problem in the 1990s was not a liquidity trap, but a credit deadlock. If there was a liquidity trap, why did the unlimited demand to hold cash on the part of bear speculators not elicit a huge increase in the Japanese money supply? In fact, the Japanese money supply increased only modestly in the 1990s. The Japanese recovery in the early 200s coincided with a rapid increase in the money supply in response to open-market purchases by the Bank of Japan. Quantitative easing worked not through a reduction of interest rates, but through the portfolio effects of increasing the quantity of cash balances in the economy, causing an increase in spending as a way of reducing unwanted cash balances.
How, then, on Laidler’s account, can we explain the feebleness of the US recovery from the 2007-09 downturn, notwithstanding the massive increase in the US monetary base? One possible answer, of course, is that the stimulative effects of increasing the monetary base have been sterilized by the Fed’s policy of paying interest on reserves. The other answer is that increasing the monetary base in a state of credit deadlock can stimulate a recovery only by changing expectations. However, long-term expectations, as reflected in the long-term real interest rates implicit in TIPS spreads, seem to have become more pessimistic since quantitative easing began in 2009. In this context, a passage, quoted by Sandilands, from the 1950 edition of Hawtrey’s Currency and Credit seems highly relevant.
If the banks fail to stimulate short-term borrowing, they can create credit by themselves buying securities in the investment market. The market will seek to use the resources thus placed in it, and it will become more favourable to new flotations and sales of securities. But even so and expansion of the flow of money is not ensured. If the money created is to move and to swell the consumers’ income, the favourable market must evoke additional capital outlay. That is likely to take time and conceivably capital outlay may fail to respond. A deficiency of demand for consumable goods reacts on capital outlay, for when the existing capacity of industries is underemployed, there is little demand for capital outlay to extend capacity. . .
The deadlock then is complete, and, unless it is to continue unbroken till some fortuitous circumstance restarts activity, recourse must be had to directly inflationary expedients, such as government expenditures far in excess of revenue, or a deliberate depreciation of the foreign exchange value of the money unit.