Archive for the 'credit deadlock' Category

Just How Infamous Was that Infamous Open Letter to Bernanke?

There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.

 

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Aggregate Demand and Coordination Failures

Regular readers of this blog may have noticed that I have been writing less about monetary policy and more about theory and methodology than when I started blogging a little over three years ago. Now one reason for that is that I’ve already said what I want to say about policy, and, since I get bored easily, I look for new things to write about. Another reason is that, at least in the US, the economy seems to have reached a sustainable growth path that seems likely to continue for the near to intermediate term. I think that monetary policy could be doing more to promote recovery, and I wish that it would, but unfortunately, the policy is what it is, and it will continue more or less in the way that Janet Yellen has been saying it will. Falling oil prices, because of increasing US oil output, suggest that growth may speed up slightly even as inflation stays low, possibly even falling to one percent or less. At least in the short-term, the fall in inflation does not seem like a cause for concern. A third reason for writing less about monetary policy is that I have been giving a lot of thought to what it is that I dislike about the current state of macroeconomics, and as I have been thinking about it, I have been writing about it.

In thinking about what I think is wrong with modern macroeconomics, I have been coming back again and again, though usually without explicit attribution, to an idea that was impressed upon me as an undergrad and grad student by Axel Leijonhufvud: that the main concern of macroeconomics ought to be with failures of coordination. A Swede, trained in the tradition of the Wicksellian Stockholm School, Leijonhufvud immersed himself in the study of the economics of Keynes and Keynesian economics, while also mastering the Austrian literature, and becoming an admirer of Hayek, especially Hayek’s seminal 1937 paper, “Economics and Knowledge.”

In discussing Keynes, Leijonhufvud focused on two kinds of coordination failures.

First, there is a problem in the labor market. If there is unemployment because the real wage is too high, an individual worker can’t solve the problem by offering to accept a reduced nominal wage. Suppose the price of output is $1 a unit and the wage is $10 a day, but the real wage consistent with full employment is $9 a day, meaning that producers choose to produce less output than they would produce if the real wage were lower, thus hiring fewer workers than they would if the real wage were lower than it is. If an individual worker offers to accept a wage of $9 a day, but other workers continue to hold out for $10 a day, it’s not clear that an employer would want to hire the worker who offers to work for $9 a day. If employers are not hiring additional workers because they can’t cover the cost of the additional output produced with the incremental revenue generated by the added output, the willingness of one worker to work for $9 a day is not likely to make a difference to the employer’s output and hiring decisions. It is not obvious what sequence of transactions would result in an increase in output and employment when the real wage is above the equilibrium level. There are complex feedback effects from a change, so that the net effect of making those changes in a piecemeal fashion is unpredictable, even though there is a possible full-employment equilibrium with a real wage of $9 a day. If the problem is that real wages in general are too high for full employment, the willingness of an individual worker to accept a reduced wage from a single employer does not fix the problem.

In the standard competitive model, there is a perfect market for every commodity in which every transactor is assumed to be able to buy and sell as much as he wants. But the standard competitive model has very little to say about the process by which those equilibrium prices are arrived at. And a typical worker is never faced with that kind of choice posited in the competitive model: an impersonal uniform wage at which he can decide how many hours a day or week or year he wants to work at that uniform wage. Under those circumstances, Keynes argued that the willingness of some workers to accept wage cuts in order to gain employment would not significantly increase employment, and might actually have destabilizing side-effects. Keynes tried to make this argument in the framework of an equilibrium model, though the nature of the argument, as Don Patinkin among others observed, was really better suited to a disequilibrium framework. Unfortunately, Keynes’s argument was subsequently dumbed down to a simple assertion that wages and prices are sticky (especially downward).

Second, there is an intertemporal problem, because the interest rate may be stuck at a rate too high to allow enough current investment to generate the full-employment level of spending given the current level of the money wage. In this scenario, unemployment isn’t caused by a real wage that is too high, so trying to fix it by wage adjustment would be a mistake. Since the source of the problem is the rate of interest, the way to fix the problem would be to reduce the rate of interest. But depending on the circumstances, there may be a coordination failure: bear speculators, expecting the rate of interest to rise when it falls to abnormally low levels, prevent the rate of interest from falling enough to induce enough investment to support full employment. Keynes put too much weight on bear speculators as the source of the intertemporal problem; Hawtrey’s notion of a credit deadlock would actually have been a better way to go, and nowadays, when people speak about a Keynesian liquidity trap, what they really have in mind is something closer to Hawtreyan credit deadlock than to the Keynesian liquidity trap.

Keynes surely deserves credit for identifying and explaining two possible sources of coordination failures, failures affecting the macroeconomy, because interest rates and wages, though they actually come in many different shapes and sizes, affect all markets and are true macroeconomic variables. But Keynes’s analysis of those coordination failures was far from being fully satisfactory, which is not surprising; a theoretical pioneer rarely provides a fully satisfactory analysis, leaving lots of work for successors.

But I think that Keynes’s theoretical paradigm actually did lead macroeconomics in the wrong direction, in the direction of a highly aggregated model with a single output, a bond, a medium of exchange, and a labor market, with no explicit characterization of the production technology. (I.e., is there one factor or two, and if two how is the price of the second factor determined? See, here, here, here, and here my discussion of Earl Thompson’s “A Reformulation of Macroeconomic Theory,” which I hope at some point to revisit and continue.)

Why was it the wrong direction? Because, the Keynesian model (both Keynes’s own version and the Hicksian IS-LM version of his model) ruled out the sort of coordination problems that might arise in a multi-product, multi-factor, intertemporal model in which total output depends in a meaningful way on the meshing of the interdependent plans, independently formulated by decentralized decision-makers, contingent on possibly inconsistent expectations of the future. In the over-simplified and over-aggregated Keynesian model, the essence of the coordination problem has been assumed away, leaving only a residue of the actual problem to be addressed by the model. The focus of the model is on aggregate expenditure, income, and output flows, with no attention paid to the truly daunting task of achieving sufficient coordination among the independent decision makers to allow total output and income to closely approximate the maximum sustainable output and income that the system could generate in a perfectly coordinated state, aka full intertemporal equilibrium.

This way of thinking about macroeconomics led to the merging of macroeconomics with neoclassical growth theory and to the routine and unthinking incorporation of aggregate production functions in macroeconomic models, a practice that is strictly justified only in a single-output, two-factor model in which the value of capital is independent of the rate of interest, so that the havoc-producing effects of reswitching and capital-reversal can be avoided. Eventually, these models were taken over by modern real-business-cycle theorists, who dogmatically rule out any consideration of coordination problems, while attributing all observed output and employment fluctuations to random productivity shocks. If one thinks of macroeconomics as an attempt to understand coordination failures, the RBC explanation of output and employment fluctuations is totally backwards; productivity fluctuations, like fluctuations in output and employment, are the not the results of unexplained random disturbances, they are the symptoms of coordination failures. That’s it, eureka! Solve the problem by assuming that it does not exist.

If you are thinking that this seems like an Austrian critique of the Keynesian model or the Keynesian approach, you are right; it is an Austrian critique. But it has nothing to do with stereotypical Austrian policy negativism; it is a critique of the oversimplified structure of the Keynesian model, which foreshadowed the reduction ad absurdum or modern real-business-cycle theory, which has nearly banished the idea of coordination failures from modern macroeconomics. The critique is not about the lack of a roundabout capital structure; it is about the narrow scope for inconsistencies in production and consumption plans.

I think that Leijonhufvud almost 40 years ago was getting at this point when he wrote the following paragraph near toward end of his book on Keynes.

The unclear mix of statics and dynamics [in the General Theory] would seem to be main reason for later muddles. One cannot assume that what went wrong was simply that Keynes slipped up here and there in his adaptation of standard tools, and that consequently, if we go back and tinker a little more with the Marshallian toolbox his purposes will be realized. What is required, I believe, is a systematic investigation from the standpoint of the information problems stressed in this study, of what elements of the static theory of resource allocation can without further ado be utilized in the analysis of dynamic and historical systems. This, of course, would be merely a first step: the gap yawns very wide between the systematic and rigorous modern analysis of the stability of simple, “featureless,” pure exchange systems and Keynes’ inspired sketch of the income-constrained process in a monetary exchange-cum production system. But even for such a first step, the prescription cannot be to “go back to Keynes.” If one must retrace some step of past developments in order to get on the right track – and that is probably advisable – my own preference is to go back to Hayek. Hayek’s Gestalt-conception of what happens during business cycles, it has been generally agreed, was much less sound that Keynes’. As an unhappy consequence, his far superior work on the fundamentals of the problem has not received the attention it deserves. (pp. 401-02)

I don’t think that we actually need to go back to Hayek, though “Economics and Knowledge” should certainly be read by every macroeconomist, but we do need to get a clearer understanding of the potential for breakdowns in economic activity to be caused by inconsistent expectations, especially when expectations are themselves mutually dependent and reinforcing. Because expectations are mutually interdependent, they are highly susceptible to network effects. Network effects produce tipping points, tipping points can lead to catastrophic outcomes. Just wanted to share that with you. Have a nice day.

Scott Sumner, Meet Robert Lucas

I just saw Scott Sumner’s latest post. It’s about the zero fiscal multiplier. Scott makes a good and important point, which is that, under almost any conditions, fiscal policy cannot be effective if monetary policy is aiming at a policy objective that is inconsistent with that fiscal policy. Here’s how Scott puts it in his typical understated fashion.

From today’s news:

The marked improvement in the labor market since the U.S. central bank began its third round of quantitative easing, or QE3, has added an edge to calls by some policy hawks to dial down the stimulus. The roughly 50 percent jump in monthly job creation since the program began has even won renewed support from centrists, raising at least some chance the Fed could ratchet back its buying as early as next month.

I hope I don’t have to do any more of these.  The fiscal multiplier theory is as dead as John Cleese’s parrot.  The growth in jobs didn’t slow with fiscal austerity, it sped up!  And the Fed is saying that any job improvement due to fiscal stimulus will be offset with tighter money.  They talk like the multiplier is zero, and their actions produce a zero multiplier.

This is classic Sumner, and he deserves credit for rediscovering an argument that Ralph Hawtrey made in 1925, but was ignored and then forgotten until Sumner figured it out for himself. When I went through Hawtrey’s analysis in my recent series of posts on Hawtrey and Keynes, Scott immediately identified the identity between what Hawtrey was saying and what he was saying. So up to this point, I am with Scott all the way. But then he loses me, by asking the following question

Has there ever been a more decisive refutation of a major economic theory?

What’s wrong with that question? Well, it seems to me to fly in the face of another critique by another famous economist whom, I think, Scott actually knows: Robert Lucas. Almost 40 years ago, Lucas published a paper about the Phillips Curve in which he argued that the existence of an empirical relationship between inflation and unemployment, even if empirically well-founded, was not a relationship that policy makers could use as a basis for their policy decisions, because the expectations (of low inflation or stable prices) under which the negative relationship between inflation and unemployment was observed would break down once policy makers used that relationship to try to reduce unemployment by increasing inflation. That simple point, dressed up with just enough mathematical notation to obscure its obviousness, helped Lucas win the Noble Prize, and before long became widely known as the Lucas Critique.

The crux of the Lucas Critique is that economic theory posits deep structural relationships governing economic activity. These structural relationships are necessarily sensitive to the expectations of decision makers, so that no observed empirical relationship between economic variables is invariant to the expectational effects of the policy rules governing policy decisions. Observed relationships between economic variables are useless for policy makers unless they understand those deep structural relationships and how they are affected by expectations.

But now Scott seems to be turning the Lucas Critique on its head by saying that the expectations that result from a particular policy regime — a policy regime that has been subjected to withering criticism by none other than Scott himself – refutes a structural theory (that government spending can increase aggregate spending and income) of how the economy works. I don’t think so. The fact that the Fed has adopted and tenaciously sticks to a perverse reaction function cannot refute a theory in which the Fed’s reaction function is a matter of choice not necessity.

I agree with Scott that monetary policy is usually the best tool for macroeconomic stabilization. But that doesn’t mean that fiscal policy can never ever promote recovery. Even Ralph Hawtrey, originator of the “Treasury view” that fiscal policy is powerless to affect aggregate spending, acknowledged that, in a credit deadlock, when expectations are so pessimistic that the monetary authority is powerless to increase private spending, deficit spending by the government financed by money creation might be the only way to increase aggregate spending. That, to be sure, is a pathological situation. But, with at least some real interest rates, currently below zero, it is not impossible to suppose that we are, or have been, in something like a Hawtreyan credit deadlock. I don’t say that we are in one, just that it’s possible that we are close enough to being there that we can’t confidently exclude the possibility, if only the Fed would listen to Scott and stop targeting 2% inflation, of a positive fiscal multiplier.

With US NGDP not even increasing at a 4% annual rate, and the US economy far below its pre-2008 trendline of 5% annual NGDP growth, I don’t understand why one wouldn’t welcome the aid of fiscal policy in getting NDGP to increase at a faster rate than it has for the last 5 years. Sure the economy has been expanding despite a sharp turn toward contractionary fiscal policy two years ago. If fiscal stimulus had not been withdrawn so rapidly, can we be sure that the economy would not have grown faster? Under conditions such as these, as Hawtrey himself well understood, the prudent course of action is to err on the side of recklessness.

They Come not to Praise Market Monetarism, but to Bury It

For some reason – maybe he is still annoyed with Scott Sumner – Paul Krugman decided to channel a post by Mike Konczal purporting to show that Market Monetarism has been refuted by the preliminary first quarter GDP numbers showing NGDP increasing at a 3.7% rate and real GDP increasing at a 2.5% rate in Q1. To Konczal and Krugman (hereinafter K&K) this shows that fiscal policy, not monetary policy, is what matters most for macroeconomic performance. Why is that? Because the Fed, since embarking on its latest splurge of bond purchasing last September, has failed to stimulate economic activity in the face of the increasingly contractionary stance of fiscal policy since them (the fiscal 2013 budget deficit recently being projected to be $775 billion, a mere 4.8% of GDP).

So can we get this straight? GDP is now rising at about the same rate it has been rising since the start of the “recovery” from the 2007-09 downturn. Since September monetary policy has become easier and fiscal policy tighter. And that proves what? Sorry, I still don’t get it. But then again, I was always a little slow on the uptake.

Marcus Nunes, the Economist, Scott Sumner, and David Beckworth all weigh in on the not very devastating K&K onslaught. (Also see this post by Evan Soltas written before the fact.) But let me try to cool things down a bit.

If we posit that we are still in something akin to a zero-lower-bound situation, there are perfectly respectable theoretical grounds on which to recommend both fiscal and monetary stimulus. It is true that monetary policy, in principle, could stimulate a recovery even without fiscal stimulus — and even in the face of fiscal contraction — but for monetary policy to be able to be that effective, it would have to operate through the expectations channel, raising price-level expectations sufficiently to induce private spending. However, for good or ill, monetary policy is not aiming at more than a marginal change in inflation expectations. In that kind of policy environment, the potential effect of monetary policy is sharply constrained. Hence, the monetary theoretical case for fiscal stimulus. This is classic Hawtreyan credit deadlock (see here and here).

If monetary policy can’t do all the work by itself, then the question is whether fiscal policy can help. In principle it could if the Fed is willing to monetize the added debt generated by the fiscal stimulus. But there’s the rub. If the Fed has to monetize the added debt created by the fiscal stimulus — which, for argument’s sake, let us assume is more stimulative than equivalent monetary expansion without the fiscal stimulus — what are we supposed to assume will happen to inflation and inflation expectations?

Here is the internal contradiction – the Sumner critique, if you will – implicit in the Keynesian fiscal-policy prescription. Can fiscal policy work without increasing the rate of inflation or inflation expectations? If monetary policy alone cannot work, because it cannot break through the inflation targeting regime that traps us at the 2 percent inflation ceiling, how is fiscal policy supposed to work its way around the 2% inflation ceiling, except by absolving monetary policy of the obligation to keep inflation at or below the ceiling? But if we can allow the ceiling to be pierced by fiscal policy, why can’t we allow it to be pierced by monetary policy?

Perhaps K&K can explain that one to us.

Liquidity Trap or Credit Deadlock

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.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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