Keynes and the Liquidity Trap

Keynes and the Liquidity Trap

In his 1935 New Year's Day letter to George Bernard Shaw Keynes indicated that he was writing a book that would revolutionize economic theory. Keynes's theory would describe a real world economy where liquidity and money contracts play a dominant role in the organization of production and exchange processes (Davidson).

Without question, the greatest advances in economic thinking in the twentieth century have been associated with the name and work of John Maynard Keynes. His most important contributions were produced in the years of the Great Depression. It was then that he formulated his General Theory of Employment, Interest and Money, a work that broke sharply with the orthodox neo-classical tradition (Barber).

The Liquidity trap situation occurs when investment profits from stocks or capital fall below expectations. When that happens, the next natural step is that people decrease their investing activities, which starts a recession, and cash assets in banks increase. Individuals and companies then go on holding cash because the expectation is that spending and investment will be low. This then is the self-fulfilling trap.

Put yet another way, Keynes' liquidity trap develops when circumstances exist where the interest rates for short-term investment is zero. In this situation, putting more cash into circulation does not impact at all on either output or prices.

"There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest" (Keynes 207)

The quantity theory of money, on the other hand, maintains that prices and output are, approximately proportional to the money supply. These two postulations are often contrasted when speaking of the liquidity trap.

What Keynes is saying is that cash supply impacts prices and production only via the nominal interest rate -- the interest rate before inflation adjustment. Improving the cash supply brings down the interest rate through a money demand formula. Decreased interest rates encourage production and expenditures. However, this nominal, short-term interest rate cannot be below zero, based on a basic arbitrage (attempting to profit by exploiting price differences) case: you wouldn't loan someone 100 dollars unless you receive at least 100 dollars in return.

According to Keynes, once the money supply has been increased to a level where the short-term interest rate is zero, there will be no further effect on either output or prices, no matter by how much money supply is increased

And, then, Keynes lays out the main purpose of his General Theory in Chapter 18:

"We take as given the existing skill and quantity of available labour, the existing quality and quantity of available equipment, the existing technique, the degree of competition, the tastes and habits of the consumer, the disutility of different intensities of labour and of the activities of supervision and organisation, as well as the social structure, including the forces, other than our variables set forth below, which determine the distribution of the national income. This does not mean that we assume these factors to be constant but merely that, in this place and context, we are not considering or taking into account the effects and consequences of changes in them" (Keynes 245).

The Great Depression of the 1920s and 1930s gave birth to the ideas behind Keynes' liquidity trap theory. During that dreadful time period, the nominal interest rate, for the short-term, was about .05 per cent, calculated using three-month Treasuries.

As the recollections of that Depression melted into the past, as usual, the challenges to the liquidity trap popped up and many economists regarded it as a theoretical oddity. Keynes, in his brilliance, must have foreseen the criticism when he penned:

"The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds" (Keynes viii).

During the 1990s, the liquidity trap collected more interest with the gathering of new information. That short-term nominal interest rate, this time in Japan plummeted to "nil" during the later 1990s. And, through both established and non-established actions, the Bank of Japan (BoJ) increased the monetary base, more than doubling it to jack up prices and encourage demand.

'Quantitative easing' became the BoJ guiding principle for about the first six years of the new century. This increased the monetary base by over 70 per cent in that period. By most accounts, however, the effect on prices was sluggish at best. (As long as five years after the beginning of quantitative easing, the changes in the CPI and the GDP deflator were still only starting to approach positive territory) (Hock).

It relies on a general equilibrium model where total demand depends on existing and probable future real interest rates rather than just the current rate as in the original Keynes' models. Using today's framework, the liquidity trap occurs when the zero bound on the short-term nominal interest rate prevents the central bank from fully accommodating sufficiently large deflationary shocks by interest rate cuts (Eggertsson).

Problems with the General Theory?

This would not be a comprehensive research paper if we do not look at the critical view of Keynes's work. In that perspective lies much more to learn of his genius, and his faults.

Keynes may have mistaken a "chapter" to be the "whole book." This could be the only problem with his General Theory. He wrote in a time when even close-to-zero interest wasn't low enough to bring back full employment, and he examined the consequence of that -- especially, the snare in which both the Bank of England and the Federal Reserve found themselves, incapable of generating employment no matter how much they attempted to improve the money supply. He was aware that it had not always been that way. But he thought, wrongly, that the monetary circumstances of the 1930s would be the paradigm for the future.

But wasn't -- not even close. The financial conditions of the 1930s have not been back. In the U.S. The period of very low interest ended in the 1950s -- (although we are having our second near-Japan occurrence since the turn of the century.) Yet the United States has, for the most part, achieved satisfactory levels of demand. The situation in Britain is the same. And even when there is above average unemployment in Europe, it seems to have more to do with supply-side issues than with lack of demand.

So, why was Keynes wrong? Partially because he underestimated the capacity of developed economies to shake off "retreating" returns. Keynes's "euthanasia of the rentier" was based on the assumption that as assets grow, money-making private venture projects become more difficult to locate, so that the marginal efficiency of capital decreases. Between wars in Britain, with the laudable period of industrialization behind it, that perspective may have seemed logical. But post-World War II a mixture of technological innovation and revitalized population growth unlocked significant new investment possibilities. And although Ben Bernanke, chairman of the Federal Reserve, has warned of a "global savings glut," Keynes's prediction of the death of the "rentier" does not seem close at hand.

Second, Keynes had no idea that the future would hold persistent inflation (nor did anyone else at the time.) This would naturally lead him to be excessively pessimistic about the future prospects for monetary policy. Of course, that meant he didn't address the policy issues created by continual inflation, which worried economists in the 1970s and 1980s, and led some to declare a crisis in economic theory.

However, bottom line is that a failure to address issues nobody could ever think of in the 1930s cannot be thought of as a flaw in Keynes's study. Now that inflation has settled back, Keynes looks quite relevant again.

Japan's Lost Decade

The economic miracle ended abruptly at the very start of the 1990s. In the late 1980s, abnormalities within the Japanese economic system had fuelled a massive wave of speculation by Japanese companies, banks and securities companies. Briefly, a combination of incredibly high land values and incredibly low interest rates led to a position in which credit was both easily available and extremely cheap. This led to massive borrowing, the proceeds of which were invested mostly in domestic and foreign stocks and securities.

Recognizing that this bubble was unsustainable (resting, as it did, on unrealizable land values - the loans were ultimately secured on land holdings), the Finance Ministry sharply raised interest rates. This popped the bubble in spectacular fashion, leading to a massive crash in the stock market. It also led to a debt crisis; a large proportion of the huge debts that had been run up turned bad, which in turn led to a crisis in the banking sector, with many banks having to be bailed out by the government (The Lost Decade - Japan's Economic Crisis).

Eventually, many become unsustainable, and a wave of consolidation took place (there are now only four national banks in Japan). 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.