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In his New York Times article of January 11, 2012, the Nobel laureate Paul Krugman wrote,

If nothing else, we've learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it's a very real threat, and if and when it ends we should nonetheless be guarding against its return — which means that there's a very strong case both for a higher inflation target, and for aggressive policy when unemployment is high at low inflation. The bottom line is that the Fed almost surely won't, and very surely shouldn't, start raising interest rates any time soon.

But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?

The Origin of the Liquidity-Trap Concept

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Thus, spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual's earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

Consequently, a vicious circle sets in: the decline in people's confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates.

Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money, so it is held.

In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further.

This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people's demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply.

Keynes wrote,

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. In this event the monetary authority would have lost effective control over the rate of interest.

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects — what matters here is that a lot of money must be pumped, which is expected to boost consumers' confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby reestablishing the circular flow of money.

Do Individuals Save Money?

In the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this is seen that they save less.

Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed that they save more. Observe that in the popular — i.e., Keynesian — way of thinking, savings is bad news for the economy: the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)

Now, contrary to popular thinking, individuals don't save money as such. The chief role of money is as a medium of exchange. Also, note that people don't pay with money but rather with goods and services that they have produced.

For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange. Again, money is just employed to exchange goods and services.

To suggest then that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.

Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some more or less definite point in the future).

Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer. The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter the so-called real economic growth. Likewise a change in the supply of money doesn't have any power to grow the real economy.

Contrary to popular thinking we suggest that a liquidity trap does not emerge in response to consumers' massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.

Liquidity Trap and the Shrinking Pool of Real Savings

As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and nonproductive activities. Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than the amount it releases. This excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings.

This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real savings exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.)

Needless to say, once the economy falls into a recession because of a falling pool of real saving, any government or central-bank attempts to revive the economy must fail.

Not only will these attempts not revive the economy; they will deplete the pool of real savings further, thereby prolonging the economic slump.

Likewise any policy that forces banks to expand lending "out of thin air" will further damage the pool and will reduce further banks' ability to lend.

The essence of lending is real savings and not money as such. It is real savings that imposes restrictions on banks' ability to lend. (Money is just the medium of exchange, which facilitates real savings.)

Note that without an expanding pool of real savings any expansion of bank lending is going to lift banks' nonperforming assets.

Contrary to Krugman, we suggest that the US economy is trapped, not because of a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings. What is required to fix the economy is not to generate more inflation but the exact opposite. Setting a higher inflation target, as suggested by Krugman, will only weaken the pool of real savings further and will guarantee that the economy will stay in a depressed state for a prolonged time.