Keynes and the Liquidity Trap Thesis

  • Length: 8 pages
  • Sources: 8
  • Subject: Economics
  • Type: Thesis
  • Paper: #39071283

Excerpt from Thesis :

Critically for the long-term economic situation, it meant many Japanese firms were lumbered with massive debts, affecting their ability for capital investment. It also meant credit became very difficult to obtain, due to the beleaguered situation of the banks; even now the official interest rate is at 0% and have been for several years, and despite this credit is still difficult to obtain

Overall, this has led to the phenomenon known as the "lost decade"; economic expansion came to a total halt in Japan during the 1990s. The impact on everyday life has been rather muted, however. Unemployment runs reasonably high, but not at crisis levels (the official figure is a little under 5%, but this is a considerable underestimate - the real level is probably around twice that). This has combined with the traditional Japanese emphasis on frugality and saving (saving money is a cultural habit in Japan) to produce a quite limited impact on the average Japanese family, which continues much as it did in the period of the miracle (The Lost Decade - Japan's Economic Crisis).

Lessons Learned?

Evidently not in the United States. If we look at a comparison to the government spending in Japan during that decade vs. President Obama's spending to "get the country moving again," we have not learned anything.

Keynesian "pump-priming" in a recession has often been tried, and as an economic stimulus it is overrated. The money that the government spends has to come from somewhere, which means from the private economy in higher taxes or borrowing. The public works are usually less productive than the foregone private investment (Barack Obama-san).

In 1992, Japanese Prime Minister Kiichi Miyazawa faced falling property prices and a stock market that had sunk 60% in three years. Mr. Miyazawa's Liberal Democratic Party won re-election promising that Japan would spend its way to becoming a "lifestyle superpower." The country embarked on a great Keynesian experiment (Barack Obama-san):

August 1992: 10.7 trillion yen ($85 billion). Japan passed its largest-ever stimulus package to that time, with 8.6 trillion yen earmarked for public works, 1.2 trillion to expand loan quotas for small- and medium-sized businesses and 900 billion for the Japan Development Bank.

April 1993: 13.2 trillion yen. At exchange rates of the day, this was a whopping $117 billion giveaway, again mostly for public works and small businesses.

September 1993: 6.2 trillion yen. Mr. Hosokawa announced a compromise "smaller" stimulus of $59 billion, along with minor deregulation. He dropped plans for an income-tax cut. The stimulus included 2.9 trillion yen in low-interest home financing, one trillion yen for "social infrastructure," and another trillion for business. The economy didn't respond.

This continued on and on for several years of more government spending to "save" the economy.

Japan's economy grew anemically over that decade, but as the nearby chart shows, its national debt exploded. Only in this decade, with a monetary reflation and Prime Minister Junichiro Koizumi's decision to privatize state assets and force banks to acknowledge their bad debts, did the economy recover. Yet recent governments have rolled back Mr. Koizumi's reforms and returned to their spending habits (Barack Obama-san).

The most reassuring conclusion to emerge from an examination of government policies, especially monetary and fiscal policies, that followed this century's major equity market bubbles (including Japan's in 1989 and America's in 1929) is their extraordinary ineptness. Such mistakes should be easy to avoid, yet a need for caution arises from the fact that such mistakes were made by Japan even with the benefit of lessons provided by Keynes's General Theory of Employment, Interest, and Money, and Milton Friedman and Anna Schwartz's Monetary History of the United States, published in 1963. These works provide a comprehensive guide to avoiding post-bubble mistakes in monetary policy.(Makin)

Three basic lessons of monetary policy follow from Japan's recent experience and from the analyses of monetary policy by Keynes and Friedman. These are: maintain stable monetary base growth; avoid targeting nominal, or market, interest rates -- especially while inflation rates are falling or negative; and do not let deflation, a falling price level, take hold (Makin).

The Great Depression

Of course, the U.S. didn't have the expertise of Keynes yet when the Depression hit. He wrote his book toward the very end of it in the mid-1930s. He did lecture and write other pieces about that time and the Depression. However, we might reach a different conclusion about the cause of the Depression and whether or not it was a "liquidity trap," or a lack of spending.

The experience of the U.S. economy during the mid-1930s, when short-term nominal interest rates were continuously close to zero, is sometimes taken as evidence that monetary policy was ineffective and the economy was in a "liquidity trap." Close examination of the historical policy record for the period indicates that the evidence does not support such assertions. The incomplete and erratic recovery from the Great Depression can be traced to a failure to pursue consistently expansionary policy resulting from an incorrect understanding of monetary policy in an environment of very low short-term nominal interest rates (Orphanides).

Keynes argued that the Government should increase spending during that time. Was he right? Did the lack of spending increase the depth of the problem? We'll never know.


"Barack Obama-san." 16 December 2008. Wall Street Journal Online. 25 May 2009 .

Barber, W.J. "The Economics of Keynes' General Theory." Barber, W.J. A History of Economic Thought. Penguin Books, 1967. 227-251.

Davidson, P. "KEYNES'S SERIOUS MONETARY THEORY:." 2007. New York University. 25 May 2009 .

Eggertsson, Gauti B. "The New Palgrave Dictionary of Economics Online: liquidity trap." 2008. Dictionary of Economics. 25 May 2009 .

Hock, Melvin Koh Kint. "Orthodoxing Monetary Policy: Policital Opposition and the Road Ahead for the Bank of Japan." Asian Journal of Public Affairs (2008): 10-21, Vol. 1, No. 2.

Johnson, H. "Keynes General Theory After Twenty-Five Years." 1961. University of Hong Kong. 25 May 2009 .

Keynes, J.M. The General Theory of Employment, Interest and Money. Cambridge, England: Macmillan Cambridge University Press, 1936.

Makin, J. "Japan's Lost Decade." 2001. American Enterprise Institute. 25 May 2009 .

Orphanides, Athanasios. "Monetary policy in deflation: the liquidity trap in history and practice." 14 January 2004. Science Direct. 25 May 2009 .

Pigou, A.C. Keynes's General Theory - A Retrospective View. READ Books, 2007.

"The Lost Decade - Japan's Economic Crisis." n.d. Japan - 101. 25 May 2009 .

Cite This Thesis:

"Keynes And The Liquidity Trap" (2009, May 25) Retrieved January 22, 2017, from

"Keynes And The Liquidity Trap" 25 May 2009. Web.22 January. 2017. <>

"Keynes And The Liquidity Trap", 25 May 2009, Accessed.22 January. 2017,