I read an article in the Financial Times earlier this week (September 23, 2023) -…
There are several different strands of mainstream economic thinking and these differences manifest in the way they think about monetary and fiscal policy. The extreme mainstream position is that fiscal policy is ineffective because it 100 per cent crowds out private spending. The only role for aggregate policy then is to allow an independent (politically speaking) central bank to adjust interest rates up and down to regulate inflation (via expectations). There isn’t much for economists to do if that view was accurate. Then there are mainstreamers who think that budget deficits are generally damaging to private spending because they drive up allegedly drive up interest rates and crowd out private spending, the latter which, is considered to be more efficient because it is backed by the so-called wisdom of the “market”. So generally monetary policy should be used to stabilise aggregate demand such that inflation is stable. However, this group of economists find some time for budget deficits when there is a “liquidity trap”. From the perspective of Modern Monetary Theory (MMT) – whether there is a liquidity trap or not is irrelevant.
Mainstream economists consider that in the “long-run” stable inflation is a sufficient condition for stable real economic growth. In this sense, the liquidity trap group are more or less accord with the extreme position that monetary policy is the preferred instrument and then only if it is politically neutral (independent).
But where this camp separate from the extremists is in what they consider to be the special case which they call the “liquidity trap”. When an economy enters a liquidity trap they say that monetary policy loses its capacity to influence aggregate demand and only fiscal policy (deficits) can be effective.
Generally these economists will identify themselves as Keynesian or New Keynesian and many so-called “progressive” economists fit into this category, however ill-defined it might be.
The Keynesian link is usually made by appealing to a section in Keynes 1936 The General Theory of Employment, Interest and Money – specifically Chapter 15, Section II.
Keynes talked about liquidity preference in Chapter 13 of the General Theory where he introduced the transactions-motive for holding cash balances. That is, people will hold cash to allow them to purchases goods and services on a daily basis. In Chapter 15, he expounded on this in more detail and came up with several distinct motives for holding cash, including:
(i) The Income-motive. – One reason for holding cash is to bridge the interval between the receipt of income and its disbursement …
(ii) The Business-motive. – Similarly, cash is held to bridge the interval between the time of incurring business costs and that of the receipt of the sale-proceeds …
(iii) The Precautionary-motive. – To provide for contingencies requiring sudden expenditure and for unforeseen opportunities of advantageous purchases, and also to hold an asset of which the value is fixed in terms of money to meet a subsequent liability fixed in terms of money, are further motives for holding cash.
These motives are largely driven by the state of the business cycle (that is, level of economic activity) and institutional arrangements relating to the “cheapness and the reliability of methods of obtaining cash”.
He added a further motive – the Speculative-motive which he said was “particularly important in transmitting the effects of a change in the quantity of money”.
Most of the claims that monetary policy is “effective” (by which Keynesians mean – capable of altering aggregate demand) arise from this “motive”. Keynes said:
… by playing on the speculative-motive that monetary management (or, in the absence of management, chance changes in the quantity of money) is brought to bear on the economic system. For the demand for money to satisfy the former motives is generally irresponsive to any influence except the actual occurrence of a change in the general economic activity and the level of incomes; whereas experience indicates that the aggregate demand for money to satisfy the speculative-motive usually shows a continuous response to gradual changes in the rate of interest, i.e. there is a continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest as given by changes in the prices of bonds and debts of various maturities.
In other words (grappling with what I consider to be Keynes’ turgid prose) people will hold more cash when interest rates are lower and vice versa. Why would that be the case?
Keynes argued that monetary authorities (he called them “the banking system”) can normally:
… purchase (or sell) bonds in exchange for cash by bidding the price of bonds up (or down) in the market by a modest amount; and the larger the quantity of cash which they seek to create (or cancel) by purchasing (or selling) bonds and debts, the greater must be the fall (or rise) in the rate of interest.
He is referring to “open market operations” here which have been normal liquidity management operations of central banks. Please read my blog – Budget deficits do not cause higher interest rates – for more discussion on this point.
To understand this better there are various concepts of bond yields that are used in the markets. The yield indicates the cash that will be returned from the investment and is usually expressed in percentage terms. There are several concepts of yield that can be defined.
- Coupon or Nominal Yield – If a bond has a face value of $1,000 and is paying 8 per cent in interest, the coupon rate, then the nominal yield is 8 per cent. The investor will thus receive $80 per annum until maturity. The coupon yield remains constant throughout the life of the bond.
- Current Yield – Suppose you purchase an 8 per cent $1,000 bond for $800 in the secondary market. Irrespective of the price you pay, the bond entitles you to receive $80 per year in coupon payments. But unlike the previous example, the $80 payment per year until maturity represents a higher current yield than 8 per cent. The actual yield is $80/$800 = 10 per cent. So to compute current yield you simply divide the coupon by the price you paid for the bond. In general, if you buy the bond at a discount to face value, the current yield will be greater than the coupon yield, and if you buy at a premium then the current yield will be below the coupon yield.
- Yield-to-Maturity (YTM) – The current yield does not take into account the difference between purchase price of the bond and the principal payment at maturity. YTM takes into account that as well as earning interest, an investor can make a realised capital gain or loss by holding the bond until its maturity date. YTM is a measure of the investor’s true gain over the life of the bond and is the most accurate method of comparing bonds with different maturity dates and coupon values.
Example: – Assume you pay $800 for a $1,000 face value bond in the secondary market. The $200 discount on the face value is considered income or yield and must be included in the yield calculations. Assume that the 8 per cent $1,000 bond had 5 years left to maturity when it is bought for $800.
A comparison of three yield concepts gives:
- Coupon yield of 8 per cent ($80 income flow divided by $1,000 face value).
- Current yield of 10 per cent ($80 income flow divided by $800 discounted purchase price).
- YTM of 13.3 per cent ($120 divided by $900) – see below.
The computation of YTM is complex and can be simplified to the following rule of thumb:
YTM = (C + PD)/[0.5*(FV + P)]
where C is the coupon, PD is the prorated discount, FV is face value, and P is the purchase price. If the bond is trading at a premium, the numerator subtracts the prorated premium from the coupon.
In our example:
YTM = [80 + (200/5)]/[0.5*($1000 + $800)] = $120/$900 = 13.3 per cent.
When bond traders talk about yield they are usually referring to the YTM measure which is the only measure that assesses the effect of principal price, coupon rate, and time to maturity of a bond’s actual yield.
But it is clear that the yield of a fixed coupon (fixed income) bond varies inversely with its price. The price is determined in the primary market by the strength of the tender and in the secondary market by current demand and supply.
Keynes outlined the importance of the speculative-motive in an oft-quoted passage from Chapter 15 (Section III):
Thus there are certain limitations on the ability of the monetary authority to establish any given complex of rates of interest for debts of different terms and risks, which can be summed up as follows:
(2) There is the possibility … 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. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.
There was not much more to it than that. The intuitive reasoning is that everyone holds cash rather than bonds because they consider interest rates are so low they can only rise which means that purchasing bonds at existing market prices would guarantee a capital loss as their prices fell.
The central bank then cannot push rates lower and if aggregate demand is deficient at that level of rates they allegedly lose their capacity to increase spending.
The concept was developed further by John Hicks (then J.R. Hicks) after a 1936 conference at Oxford where various economists attempted to “model” the General Theory. This was the birth of the famous (but erroneous) IS-LM model that is standard fare for intermediate macroeconomics students. The reference to Hick’s two personae refers to his later dissatisfaction with the way his early work had been used by the “Keynesians” and he agreed that it was not faithful to Keynes (most significantly because it left out the essential insights into uncertainty).
It was Hicks who developed the notion of a monetary policy transmission mechanism – through which interest rates impact on the real economy. The argument was that the economy can hit a liquidity trap when everyone forms the view that interest rates can only go up. This does not have to coincide with zero nominal interest rates but clearly the latter condition will deliver the former.
There are two ways in which Hicks is now interpreted by the mainstream. First, in a liquidity trap the central bank can no longer manipulate the interest rate by managing the demand and supply of funds via open market operations because the opportunity cost of holding cash becomes irrelevant to everyone. monetary authorities lose the capacity to reduce interest rates any further because everyone wants to hold cash rather than bonds – so open market operations fail. In a liquidity trap, people will keep holding extra cash that comes into the economy irrespective of the size of the cash pool.
Second, mainstream economists think that the way monetary policy works is to influence the volume of funds available by banks for credit. So the modern version of this relates to the inflated debate (excuse the pun) surrounding quantitative easing. It hasn’t worked so the mainstream have it because investment has failed to response to the growth in the monetary base (currency and reserves) as the central bank has been exchanging cash for paper assets.
Whichever version you adopt the notion centres on the view that cash holdings are invariant to interest rates and people will demand an infinity of cash.
Currently, the very low interest rates also mean that the opportunity cost of cash (against storing the speculative balances in interest-bearing assets) is very low and so there is no difference between having a government bond or cash.
The mainstream view – for those who believe that liquidity traps “switch off” monetary policy effectiveness and “turn on” fiscal policy effectiveness is that once the economy recovers there is a massive inflation threat sitting in the system in the form of the build up of the monetary base – if the central bank had acted contrary to their advice and believed that monetary policy could still stimulate demand.
This is of-course the current situation. Central bank reserves around the globe have expanded dramatically – especially in the US and UK (and Japan) as central banks have pursued quantitative easing to little end.
The view is captured in a Bloomberg opinion piece (July 5, 2011) – Sorrow and Pity of Another Liquidity Trap – by Bradley De Long – who feigns sorrow for not remembering the work of Hicks in particular the liquidity trap.
He asserts that “(t)here is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down” and then suggests that he has been confounded by the apparent abrogation of that law when it comes to US Treasury bond yields. He notes that between 2002 and 2007 the increased supply of bonds led him to conclude that:
this expanded supply would exert substantial pressure on interest rates to rise.
But he rationalises this by arguing that the “demand for Treasuries was inordinately high, in part because the supply of alternatives was low” and suggests that private bond issuers reduced their demand for funds because they lacked “confidence” in the set of available investment opportunities.
He admits to thinking that it was only a matter of time before “the market’s appetite for Treasury bonds at high prices and low interest rates had to reach its limit” given that “(s)upply and demand isn’t just a good idea — it’s the law”.
He also says that in 2008 he considered the US “had a little time for expansionary fiscal policy to boost the economy … before the bond-market vigilantes would arrive” and:
They would demand higher interest rates on Treasury bonds, which would begin seriously crowding out the benefits of fiscal stimulus. The U.S. government would have to react, pivoting from fighting joblessness, via deficit spending, to reassuring the bond market via long-run tax increases and spending cuts to Medicare and Medicaid.
So he subscribes to the mainstream crowding out story and the view that private bond markets essentially call the shots and the government is a passive player in seeking funds.
Of-course none of this happened as he acknowledges (“it didn’t happen in 2009. It didn’t happen in 2010. And it isn’t happening in 2011”) and it will not happen in 2012. It is clear that bond markets will buy whatever debt is being issued at high prices (low yields). There is also no inflation threat emerging.
He then offers his mea culpa:
Although I worked for three years in the Clinton Treasury Department, and am a card-carrying member of the economist guild, I predicted none of this. Like most of my peers, I was wrong. Yet the most interesting thing is that I could have — should have — been right. I had read economist John Hicks; I just didn’t quite believe him.
So the only reason he was wrong is because he didn’t consider the liquidity trap to be a serious description of real possibilities despite being having sat in his “first graduate economics class in 1980” listening “to Marty Feldstein and Olivier Blanchard — two of the smartest humans I am ever likely to see” who assured him that “Hicks’s liquidity trap was a very special case, into which the economy was unlikely to wedge itself again”.
One has to question his assessment of “smartness” but that is another issue again. Please read my blog – Martin Feldstein should be ignored – for more discussion on Feldstein. Also in this blog – We are sorry – I consider some of the wisdom of Blanchard, currently chief economist at the IMF.
De Long represents the Hicks liquidity trap in terms of “that interest rates paid by creditworthy governments would remain low after a financial crisis … even in the face of enormous budget deficits that greatly expand the supply of government bonds”.
De Long claims that normally when interest rates fall (and bond prices rise) business investment is stimulated and household saving becomes less attractive – both stimulatory outcomes.
But during a financial crisis, there is “an increased desire among businesses and households to safeguard more of their wealth in cash” and total spending falls and a recession emerges.
What if the central bank conducts open market operations (with the fancy title of quantitative easing) and buys “bonds for cash”? He says that:
… when rates become so low that there’s little difference between cash and short-term government bonds, open-market operations cease having an effect; they simply swap one zero- yielding government asset for another, with their hunger to hold more safe, liquid assets unsatisfied.
This is the liquidity trap.
So he concludes that “we need deficit spending” to fill the gap left by private spending.
But even though the government runs a deficit and borrows “creating more of the safe, cashlike assets that private investors want” why is the demand for bonds so high? He doesn’t answer that. In a true liquidity trap (a la Keynes) the demand for bonds evaporates because people fear capital losses.
He concludes (channelling his version of Hicks) that “(a)s long as output remains depressed and there is slack in the economy, printing more bonds will have negligible effect in increasing interest rates” and says he is “sorry” for ignoring that message.
The point is that De Long “generally” believes deficits to be damaging for private spending because he thinks they drive up interest rates but in this special case – they are safe … for a time. Eventually the build-up in the monetary base will be inflationary in his view because supply will exceed demand. The current demand for “cash” will move into a demand for goods and services and all those reserves will be loaned out and spent.
That is the main message of Macroeconomics Mythology 101 which De Long and most other economics teach their students.
None of this has any traction from the perspective of Modern Monetary Theory (MMT). Several brief points can be made (which I have made before). You can get background detail the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary.
First, monetary policy is a dubious tool to use to counter-stabilise aggregate demand. It is not entirely clear (or predictable) which way the interest rate effects will go with respect to spending. The distributional complexities of an interest rate cut (creditors lose, debtors gain) make it hard to know what will happen. Further, the policy tool is blunt, indirect, cannot be targetted and is subject to unknown lags).
So the narrative that says that monetary policy is effective outside of a liquidity trap and powerless during a trap is highly questionable.
But we can take it even further. Whether there is a liquidity trap or not (and whatever that is) it is moot from the perspective of MMT. The fact is that a recession occurs when spending persistently falls short of the sales expectations of firms, which conditioned their decisions to employ and produce. Not wanting to accumulate inventories, firms reduce production and lay off workers.
The reasons why private spending collapses are many as are the reasons why it might not recover quickly. They can mostly be summarised by the term “lack of confidence” which is exacerbated by rising unemployment and the loss of income that accompanies it.
The early idea of a liquidity trap does not explain why bond markets cannot get enough debt even with interest rates low. There is no capital loss expectation with cash (other than via inflation) whereas bond prices are more likely to fall when interest rates (and yields) as so low than they are to rise.
At any rate, the MMT prognosis is clear. Irrespective of the level of interest rates and the state of private desire to hold cash balances the way forward when private spending collapses is for public spending to take its place.
Second, the idea that the build up of bank reserves represent a pot of funds that the banks will eventually loan out completely misunderstands the role of bank reserves. As I have noted before banks do not loan out reserves. Reserves facilitate the payments system – that is, the system that assures the millions of transactions between banks (as customers write cheques and deposit them throughout the banking system).
Banks do not make loans on the basis of the reserves they hold. They respond to demands from credit-worthy customers and have in mind what it will cost them to make the loans under current conditions. When the transactions that follow the creation of a loan transpire it might be that the is short of reserves to ensure the payments clear. It has various options. It can seek funds from wholesale markets (other banks or other lenders), use deposits (not an overnight option really) or, ultimately, it can source the funds from the central bank.
The very fact that the central bank sets a non-zero target policy rate means that it has to manage liquidity (reserves) to ensure that the rate sticks. This is an example where demand and supply rules. The centrral bank loses control of its interest rate target if there are excess funds in the system (and it doesn’t pay a return on those balances).
The point is that the chain of causality is: Demand for loan from credit-worthy customer => bank loan creates deposit => any necessary reserves to maintain payments integrity added afterwards.
So the increase in bank reserves (as in the current period) only really impacts on the central bank’s capacity to pursue a non-zero policy rate. It has to offer a return on the excess reserves to the bank equivalent to the policy rate to stop the competition in interbank market from driving the rate to zero as banks individually try to eliminate their holding of excess reserves. In aggregate, the bank transactions cannot eliminate a system-wide excess. That point thereby answers Greg Mankiw’s question – see the blog – It is a pity that he doesn’t know the answer himself – for more discussion.
Liquidity trap or not, the size of the monetary base (currency plus bank reserves) is largely irrelevant. It does not increase the risk of inflation. It does not increase the funds available to banks to lend.
Please read my blog – The role of bank deposits in Modern Monetary Theory – for more discussion on these points.
Third, what about this idea that the liquidity trap occurs when cash and bonds are near substitutes so people are indifferent between them. Note again this is a perversion of Keynes.
The options for the central bank are simple. if they want a non-zero interest rate and there are excess reserves (perhaps from deficits) they can either pay a return on the reserves or sell bonds to drain the reserves. If they pay a return on reserves (equal to its policy rate) as they are doing now in many nations then cash and bonds remain near substitutes. So what? Nothing!
If they choose not to pay a return on reserves then they have to conduct open market operations to ensure the demand and supply of reserves is at the level commensurate with the policy rate they desire. There are not other options. In that case, if there are excess reserves they have to sell bonds and then cash and bonds become imperfect substitutes (because the latter earn interest). So what? Nothing!
The fact that at times people do not care whether they hold bonds or cash is irrelevant to the main cause of recession. Fiscal policy can always restore aggregate demand irrespective of private portfolio preferences.
The point is that you can get various levels of bank reserves depending on how the central bank pursues its liquidity management in order to hit its target policy rate. None of those levels have any particular operational significance.
The mainstream then argue that if the central bank mops up these reserves it will be less inflationary than if it leaves them in the system. This view is based on the spurious – banks lend reserves argument. The inflation risk associated with government spending is the same whether the government issues debt to match its deficit or not. The inflation risk arises from the impact of the spending on the state of capacity in the economy.
The monetary impacts of the deficit spending – in the form of increased bank reserves – do not add to the inflation risk. They emerge after the transactions have taken place. Bond sales just swap on asset for another (a reserve balance or a deposit).
At any time, a bond holder could cash their bonds in and spend up big. Just about as easily as they could cash in a bank deposit and spend up big. There is no “constraint” on spending involved in the government selling bonds.
The mainstream economists were totally wrong several years ago when they predicted the business cycle was dead. Once the crisis emerged they have consistently made predictions about inflation, interest rates and debt default that have been false (I am excluding the EMU nations here for obvious reasons).
As each year passes and the empirical reality further negates their story they continue unabashed. The few (like De Long) who actually acknowledge that they were totally wrong come up with ruses (like the liquidity trap) to rationalise why they were wrong.
Their defenses are erroneous. The slow recovery has nothing to do with a liquidity trap. It has all to do with a lack of overall spending which means if private individuals are reluctant to spend (for whatever reason) then governments have to fill the gap. There is nothing more simple than that proposition.
Further, the strong continuing demand for government debt tells me that people are not scared of bond prices falling which is the original liquidity preference reason why people would hold cash instead of speculating on bond prices.
Tomorrow I will have my head buried in the latest Australian labour market statistics. With retail sales going backwards last month and the RBA revising its growth forecast down – how does the mainstream narrative that we are in the boom of our lifetimes sound to you?
That is enough for today!