Keynes's Liquidity Trap, Japan, and the Great Depression

Introduction: Keynes and the Liquidity Trap

In his New Year's Day letter to George Bernard Shaw in 1935, John Maynard Keynes indicated that he was writing a book that would revolutionize economic theory. Keynes's theory would describe a real-world economy in which 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 during 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 occurs when investment profits from stocks or capital fall below expectations. When that happens, the natural next step is that people decrease their investing activities, which starts a recession, while cash assets in banks increase. Individuals and companies then continue holding cash because the expectation is that spending and investment will remain low. This is the self-fulfilling trap.

Put another way, Keynes's liquidity trap develops when circumstances exist in which the interest rate for short-term investment is zero. In this situation, putting more cash into circulation has no impact 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, by contrast, maintains that prices and output are approximately proportional to the money supply. These two propositions are often contrasted when discussing the liquidity trap.

How the Liquidity Trap Works

What Keynes is saying is that the cash supply impacts prices and production only via the nominal interest rate — the interest rate before inflation adjustment. Increasing the money supply brings down the interest rate through a money demand formula, and decreased interest rates encourage production and expenditure. However, this nominal short-term interest rate cannot fall below zero, based on a basic arbitrage argument: you would not lend someone $100 unless you expected to receive at least $100 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 how much the money supply is expanded.

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's liquidity trap theory. During that period, the nominal short-term interest rate was approximately 0.05 percent, calculated using three-month Treasuries.

As memories of the Depression faded, challenges to the liquidity trap emerged, and many economists regarded it as a theoretical oddity. Keynes, in his brilliance, must have foreseen such criticism when he wrote:

"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 attracted renewed interest as new data accumulated. The short-term nominal interest rate in Japan plummeted to virtually nil during the later part of that decade. Through both conventional and unconventional measures, the Bank of Japan expanded the monetary base — more than doubling it — in an attempt to raise prices and stimulate demand.

"Quantitative easing" became the Bank of Japan's guiding principle for approximately the first six years of the new century, increasing the monetary base by over 70 percent during that period. By most accounts, however, the effect on prices was sluggish at best; as long as five years after quantitative easing began, changes in the CPI and the GDP deflator were only beginning to approach positive territory (Hock).

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

Problems with the General Theory

A comprehensive examination of Keynes's work must also consider critical perspectives, since it is in those critiques that much more can be learned — both about his genius and his limitations.

Keynes may have mistaken a single "chapter" for the "whole book." This could be the central problem with his General Theory. He wrote during a period when even near-zero interest rates were not low enough to restore full employment, and he examined the consequences of that situation — especially the bind in which both the Bank of England and the Federal Reserve found themselves, unable to generate employment no matter how aggressively they expanded the money supply. He was aware that conditions had not always been so dire, but he concluded, incorrectly, that the monetary circumstances of the 1930s would serve as the paradigm for the future.

That proved not to be the case — not even close. The financial conditions of the 1930s did not return. In the United States, the period of very low interest rates ended in the 1950s, though a near-Japan-style episode has recurred since the turn of the century. Yet for the most part, the United States has achieved satisfactory levels of demand. Britain's experience has been similar. And even periods of above-average unemployment in Europe appear to have more to do with supply-side issues than with insufficient demand.

So why was Keynes wrong? Partly because he underestimated the capacity of developed economies to shake off diminishing returns. Keynes's "euthanasia of the rentier" rested on the assumption that as assets grow, profitable private investment projects become harder to find, causing the marginal efficiency of capital to decline. In interwar Britain, with its great era of industrialization behind it, that perspective may have seemed reasonable. But after World War II, a combination of technological innovation and renewed population growth opened up significant new investment opportunities. And although Federal Reserve Chairman Ben Bernanke warned of a "global savings glut," Keynes's prediction of the death of the rentier does not appear imminent.

Second, Keynes had no way of foreseeing that the future would bring persistent inflation — nor did anyone else at the time. This naturally led him to be excessively pessimistic about the long-term prospects for monetary policy. It also meant he did not address the policy challenges created by sustained inflation, which preoccupied economists in the 1970s and 1980s and led some to declare a crisis in economic theory.

At the same time, a failure to address problems that no one in the 1930s could have anticipated cannot fairly be counted as a flaw in Keynes's analysis. Now that inflation has settled back to moderate levels, Keynes looks quite relevant again.

Bibliography

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

Davidson, P. "Keynes's Serious Monetary Theory." 2007. New York University. Accessed 25 May 2009. http://econ.as.nyu.edu/docs/IO/8801/DavidsonKeynesMonetary.pdf.

Eggertsson, Gauti B. "The New Palgrave Dictionary of Economics Online: Liquidity Trap." 2008. Dictionary of Economics. Accessed 25 May 2009.

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

Johnson, H. "Keynes' General Theory After Twenty-Five Years." 1961. University of Hong Kong. Accessed 25 May 2009. http://sunzi1.lib.hku.hk/hkjo/view/12/1200006.pdf.

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. Accessed 25 May 2009.

Orphanides, Athanasios. "Monetary Policy in Deflation: The Liquidity Trap in History and Practice." 14 January 2004. Accessed 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. Accessed 25 May 2009. http://www.japan-101.com/history/history_lost_decade.htm.