Tag Archives: fiscal policy

Forensic Semantics: The Meaning of Liquidity Trap

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I promise not to do too many more posts about a) macro or b) Paul Krugman. I don’t just love macro, these are not my most popular posts, and Krugman is too shrill to read on a regular basis. Nevertheless, I think I can sort through some of the recent disagreement about liquidity traps.

The term “liquidity trap” comes from Keynes. He described it as a theoretical possibility under which monetary policy would be ineffective; it would be unable to stimulate an economy in recession. Consequently, fiscal policy would be needed. To my knowledge, Keynes was not claiming that the economy ever has been in a liquidity trap; it’s simply a possibility that occurs under very specific conditions. Those conditions define “liquidity trap,” but there is disagreement over when they hold.

What is at stake here is the status of fiscal policy. If the economy sometimes experiences liquidity traps, then that is perhaps a good reason to keep fiscal policy in our toolbelt. If the economy never experiences a liquidity trap, then monetary policy strictly dominates fiscal policy: it is faster, less wasteful, and does not increase sovereign debt. It’s sometimes hard to say whether advocates and detractors of fiscal policy take those sides because of their position on liquidity traps or vice versa.

Krugman is among those who think that the world does experience liquidity traps, that we are in one now, and that we need more fiscal policy. Why does he think this? Arnold Kling does some of the forensic work and uncovers an old and a recent statement from Krugman on liquidity traps. Arnold says they are inconsistent, but I think they are perfectly consistent. The old statement:

My view … is that the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another.

The new statement:

The economy is in a liquidity trap when even a zero nominal interest rate isn’t enough to restore full employment. That’s it.

What Paul is saying is that the economy is in a liquidity trap when the nominal interest rate on short-term Treasuries is zero. When the Fed tries to expand the money supply by buying up short-term Treasuries, it is swapping cash for Treasuries. Normally, cash and Treasuries have different properties: cash has a nominal interest rate of zero and Treasuries bear some positive nominal interest rate. However, when Treasuries bear an interest rate of zero, they are basically the same as cash. They are backed by the US Government and they don’t carry interest. Why should swapping one asset for an identical asset make any real difference in the world? On this narrow point, Krugman is clearly correct: it wouldn’t make a difference at all.

Krugman is wrong, however, that this constitutes a liquidity trap, either in the sense that Keynes meant it or in the looser sense that monetary policy is ineffective, because swapping cash for short-term Treasuries is not the only (or even necessarily the best) way to conduct monetary policy. First of all, it is important to recognize that there is not just one nominal interest rate. There is an infinity of nominal interest rates. If the interest rate on short-term Treasuries is zero, the Fed can swap cash for longer-term Treasuries. It could in theory buy private bonds, or stock, or mortgage-backed securities, or even non-financial assets. In any of these cases, the Fed is increasing the amount of money in circulation, and it is removing less liquid assets. This is expansionary except in extraordinary circumstances I’ll discuss below.

Incidentally, the Fed can also conduct monetary policy by other means. It can simply print money and distribute it, the infamous “helicopter drop.” It can buy foreign currency. It can lower the interest rate or raise the penalty on excess reserves that banks hold at the Fed. It can promise to inflate more in the future. All of these actions are expansionary, again except perhaps in extraordinary circumstances.

What are the extraordinary circumstances in which all monetary policy is ineffective? Keynes got it right. Monetary policy is ineffective when people want to hoard whatever cash they can get their hands on. In technical terms, the demand for money is infinitely elastic. The point is that increasing liquidity in the system (buying illiquid assets with liquid assets, say) does not translate into more spending because people soak up whatever liquidity there is.

When is demand for money infinitely elastic? Basically never. This is what Tyler is saying in his most recent post on liquidity traps. In Tyler’s terminology, there are multiple margins on which people express preferences for liquidity. There is the money-bonds margin, and in fact, there are multiple money-bonds margins. When the nominal interest rate on short-term Treasuries is zero, that is one margin on which people are expressing a preference for liquidity. But as I argued above, there are other bonds, and people are generally willing to sacrifice liquidity for a non-zero rate of return. There is also the money-goods margin. People are generally willing to sacrifice liquidity for stuff. That is, if you give them money, they spend some of it. But since Keynes is all about aggregate spending, you can see how it would be the case that if people infinitely preferred liquidity to goods (they were unwilling to spend even if you gave them more money), then it would be desirable to have the government to engage in direct spending (fiscal policy) to boost aggregate demand.

So why does Krugman fixate on only one interest rate, on only one particular money-bonds margin? I think that it’s just a lack of imagination about what monetary policy consists of. Traditionally, monetary policy in the US has consisted primarily of open market operations on short-term US Treasuries. But there is nothing special about this particular kind of monetary expansion. If Krugman wants to call it a liquidity trap when the nominal interest rate on short-term Treasuries is zero, he needs to abandon the conclusion that fiscal policy is called for in a liquidity trap. I prefer to retain Keynes’s original meaning and conclusions by defining a liquidity trap as an infinitely elastic demand for money.

Ireland Tells Us Nothing About Austerity

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In 2008, the Keynesians emerged from hiding, where they had been since the mid-1980s. It was nice to see them, catch up, and so on. But now they won’t go away.

This week’s Buttonwood column in The Economist considers whether fiscal austerity is expansionary or contractionary. A sentence caught my eye.

Keynesian economists are also likely to counter the Canadian example [in which fiscal austerity was followed by prosperity] with that of Ireland today, where a willingness to appease the bond markets with budget cuts has been accompanied by a fall in nominal GDP of almost a fifth.

Last week in the New York Times, Christy Romer’s debut column claimed:

Ireland, Greece and Spain have all had rising unemployment after moving to cut deficits.

OK, I can agree that Ireland, Greece, and Spain all cut their deficits, and that they all had rising unemployment. I will leave aside, for this post, the question of what their unemployment rate would have been if they had not appeased the bond market, because in the US context it is irrelevant. The US is not yet on the immediate verge of a sovereign debt crisis.

What is important in the US context? Ireland, Greece, and Spain differ from the US in a way that is so inescapably essential in theory that it makes me want to revoke the credentials of any economist who cites them as evidence. Yes, dear reader, you guessed it, none of them runs its own monetary policy.

The monetary authority moves last. It incorporates the actions of the fiscal authority into its choices. If the fiscal authority decides to be austere, the monetary authority can be loose. The friendly Keynesians who cite the experiences of countries without their own currencies as evidence of the evil of austerity during a recession are trying to trick you.

The Elitist Case Against Bernanke

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Wednesday will be an interesting day, and not just because of the introduction of the iPad. It is also likely to be the start of Fed Chairman Ben Bernanke’s confirmation hearings for a second term. The final result no longer seems to be in doubt. Intrade now reports over a 90 percent probability of confirmation; last week it was in the 70s.

Bernanke’s confirmation was momentarily in jeopardy because politicians are beginning to fear the rise of populism, especially after the surprising election of Scott Brown as the new Republican Senator from deep-blue Massachusetts. Indeed, most Tea Party/End the Fed types probably would like to see Bernanke’s confirmation fail. But I think there is a strong elitist case for why Bernanke should be dismissed.

The role of the Fed is or ought to be to do whatever it takes to keep Congress and the President from messing with the economy. Among other things, this means:

  1. Using monetary policy to keep nominal GDP growing at a predictable rate.
  2. Discouraging the use of fiscal policy, both by doing #1 and by saying that it is a bad idea.
  3. Displaying an appearance of control and competence, so that the elected politicians do not get involved.

Whatever your views on the relative theoretical merits of abstract monetary and fiscal policy, monetary policy conducted by the Fed is more effective than fiscal policy conducted by Congress. In my view, even in pure theoretical terms, monetary policy can do everything that fiscal policy can, so there is no reason to use fiscal policy. Some will of course dispute this. But in practice, fiscal policy indisputably ends up being far less effective because:

  1. It is not timely. Much of the recent fiscal stimulus will not be spent until after the economy returns to full employment.
  2. It is not targeted. To be effective, fiscal policy should target idle assets and produce relatively useful stuff. Members of Congress are of course eager to spend money, but their incentives are to use the funds for political purposes rather than on useful projects employing idle people and assets.
  3. It is not temporary. When politicians use fiscal policy as an excuse to increase government expenditures on a permanent basis, any stimulative effect gets completely wiped out by increased deadweight loss of taxation and increased risk of a debt or currency crisis.

On Bernanke’s watch, nominal GDP fell below trend beginning in 2008. This slip-up caused or at least exacerbated a financial crisis that made nominal GDP fall further. Bernanke then got on TV with Hank Paulson, told everyone the sky was falling, and got Congress involved in the financial rescue effort. In addition, Bernanke has refused to say anything that might constrain Congress or dissuade it from wasting money on pseudo-stimulus. Had Bernanke kept nominal GDP growth steady, used the tools the Fed already had (quantitative easing) to buy toxic assets in the milder financial crisis (without Congress’s or Treasury’s approval or involvement), spoken out against fiscal policy, and appeared in control, the economy would be in a much better state today. For these reasons, Bernanke does not deserve to be confirmed.

Nevertheless, I do worry about who would replace him. If populist sentiment really is as powerful as they say, it could be a lot worse. I have seen lots of calls online to “End the Fed,” but proponents do not seem to realize that this would give Congress much more power over the economy and that they would not like the results. The Fed is the lesser of evils, and the Fed Chairman ought to believe this. A more populist nominee, even if he would not go so far as to abolish the Fed, would be even less likely than Bernanke to view his role as Protector of the Economy from Congress. Perhaps it is a good thing after all that there is a 90 percent chance Bernanke will be confirmed, but in a just world, he would be on the first train back to Princeton.