It’s Wednesday and also a holiday period, so just a few things today. First, I discuss a research paper that has concluded that central bankers have been using the wrong model for years which has resulted in flawed estimates of the state of capacity utilisation, and, in turn, created excessive unemployment. Second, we have a…
Whether there is a liquidity trap or not is irrelevant
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!
This Post Has 30 Comments
The liquidity trap makes me puke.
Scott Sumner is similarly unimpressed by it.
What made Keynes think the speculative motive was of prime importance? I suggest it was because he moved only in elite and wealthy circles. Plus he spent plenty of time on, and was good at stock market investing.
Nowadays, a much higher proportion of wealth and cash is in the hands of average income households. And what do these households do given extra cash? Now here’s the revelation of the century: THEY SPEND SOME OF IT. Who’d have guessed?
In other words as MMT says, given extra government spending which leads to private sector net financial assets expanding, aggregate spending and employment will rise. The effect comes from two sources: the spending as such, and second the expansion of psnfa encourages households to spend. Just forget the liquidity trap.
You wrote that a bondholder can simply cash in his bonds and spend the receipts. However, it seems to me that you are committing the fallacy of composition here. Cashing in a bond means selling it to somebody else. The seller gets spendable cash but the buyer loses just as much spendable cash. Macro-economically the effect should be nil.
Since you MMT types are keenly aware of fallacies of composition, I must be missing something.
One of the counter arguments against the ‘IS-LM is wrong’ argument is that ‘economists don’t use that model any more’.
I’m presuming that such individuals are referring to the DSGE model that I believe is in vogue. Is there much difference? I presume they are both based on the flawed ‘one representative consumer, one representative product’ aggregation.
“The seller gets spendable cash but the buyer loses just as much spendable cash.”
The buyer may lose spendable cash but clearly he was not predisposed to spend it! So it wasn’t spendable cash, it was saved cash. The exchange means that the buyer gets to keep his savings but in bond form rather than cash, whereas the seller has got rid of his savings and has something to spend.
You would have exactly the same effect if both parties had had cash and no bonds. The fallacy is that interest rates are the sole determinant of whether people save cash or spend it.
Very good, Bill! The framework you critique here is also the same one Krugman has used throughout as his basis for understanding the crisis. One can see this rather clearly in his attempts to critique MMT.
Why can’t DeLong just say, “the Fed’s target rate is at zero, zero is the lowest possible rate, therefore my preferred economic stabilization tool can’t do anything and so we have to resort to fiscal policy.” Is there any other substance to what he is saying?
Fiscal optimization at any level of public spending requires balancing tax revenues with spending while running deficits at a rate corresponding to users saving rate. In order to balance spending with tax revenues, government must destroy money through taxes before it creates money to spend in the marketplace. Recognizing that some users choose not to spend, government deficits must correspond to the users savings rate in order to maintain a given level of output. The challenge of the issuer is to spend enough money to displace savings but not enough to exceed it.
The problem we are having is that the mainstream economic profession fails to realize the chinese are “saving” dollars instead of “borrowing” dollars. One paradigm of physics does not exist in the physical world (Newtonian/Quantum) just as one paradigm of debt does not exist in the monetary world (issuer/user)
“Mainstream economists consider that in the “long-run” stable inflation is a sufficient condition for stable real economic growth.”
Dear Professor Mitchell:
Please help. I am often unclear on whether “stable inflation” in their lexicon means a predictably unchanging rate of inflation, or a predictably low inflation rate (more accurately: stable prices). Is this my failure to understand, or theirs? Are they frequently unclear on which they mean? I’m not looking to win any argument here; simply trying to understand.
“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).”
This seems a highly problematic claim. It seems beyond question that high interest rates (a la Volker) can choke off economic activity. Granted, it is a blunt instrument, but that is the whole idea behind the interest rate mechanism … that borrowers are chased out of the market in increasing order with respect to their prospects of repayment at the higher rates, whether judged by themselves or by their lenders. Investors and savers may seek the high rates, but if the central bank sets the real rate high enough, then the supply of such investments will dry up. As you say, this is not a (money) supply-limited or supply-fueled process.
Additionally, if I may put up a small defense of the business-cycle-is-dead meme.. While some meant this to mean that monetary policy and banking policy were perfect, others took it to mean that modern supply chain management had improved to that point that the kinds of inventory excess cycles that were common decades ago were a thing of the past. The current downturn is a testament of sorts to the brutally efficient nature of modern business, which doesn’t stockpile significant inventories, but rather fires workers at the drop of a hat, as it were. I think the latter meme still has some legs, though it is minor compared to the finance-apocalypse.
I would really appreciate if someone tells me whether I am wrong or if I misunderstood something but this is what I think about the topic…
Let’s fix the Krugman’s model of a liquidity trap. He assumed that there are 2 groups of agents – “patient” and “impatient”. These “patient” saved X dollars over a certain period of time A (“good times”). These “impatient” borrowed X dollars over the same period of time. He assumed that these dollars were borrowed from the “patient” agents but in reality they were borrowed from the banking system. k*X of these dollars were spent on new goods and products – the rest was used to acquire (often speculate on) existing real assets (houses, etc).
What Krugman and the others failed to realise is that:
1. That the act of borrowing X1 dollars led to spending k*X1 dollars generated an additional flow delta L/delta t which was added to aggregate demand precisely to C and I (spending on housing was accounted for as I)
This additional contribution was X1*k/A assuming X1 and k constant over the period of A. It is pretty much an equivalent of additional government spending which goes through the spending multiplier. Spending financed by money created out of nowhere exactly as if the government “printed” all of it. That credit money ended up on the accounts of the “patient” agents who incidentally can be called capitalists and rentiers. (“Impatient” were often workers).
2. Krugman and the others fail to realise that since good times are over and asset prices have fallen, the “impatient” agents cannot borrow any more. They have to pay back their debt and the prices of real assets they were speculating on (houses) – have since collapsed. We are now in period B. But what is critically important is that “patient” agents have zero intention to part with their savings. They do not want to spend. Their wealth has initially been accumulated on the balance sheets of the private banks in the banking system. However “impatient” agents slowly repay the debt – nobody can stop them from doing that if they still have some income. Even worse – they have to do so.
The net effect of “hoarding cash” visible at the aggregate level is not primary a result of lack of confidence. It is a result of debt deleveraging. This deleveraging might have been caused by loss of confidence and falling prices of real assets purchased during the phase A.
As we can see in numerous countries both I and C have collapsed. Especially the construction sector in the US is still in deep recession. (we can see that on the graphs available on Warren Mosler’s site in his latest stats pack). What we can see is that there is a negative contribution equal to X2 over the period B, mostly financed from the income of the (formerly) impatient agents. This is visible on the aggregate figures as an increase in S while I is subdued. Obviously the new value of C is affected by the spending multiplier going backwards (subtracting rather than adding the deleveraging flow divided by the new propensity to save)
(Someone who likes drawing could introduce a few tables with the balance sheets of the agents and sectors and a few graphs here)
3. Certainly desires of both groups of agents can be frustrated if austerity is introduced. “Patient” agents can be forced to spend and “impatient” may be forced to abandon repaying their debts – what obviously leads to defaults.
But it is up to the government sector to provide funds (not for “hoarding” but for repaying debt) if a depression is to be avoided. If we look at the balance sheets of the agents and the banking sector provided that the government sector accommodates the new desires of the both groups of agents – the debt which is an asset on the balance sheets of the banking sector counterweighting the banking liability (the deposits of the patient agents) is destroyed and an excessive level of reserves appears. This is the liquidity trap – an artefact of the process of repairing balance sheets of the formerly “impatient” agents. No matter how low are the interest rates – people won’t borrow. But they are not hoarding cash. Some agents repair their balance sheets what may appear as money hoarding but it is actually a process of modifying the composition of the assets of the “patient” agents whose assets from being mainly private debt are becoming mainly public debt (bonds and currency).
4. The solution to the economic problems during phase B is not to force more private debt into the system by pushing the system out of the “liquidity trap”. This was the root cause of the instability in the first case and may even not be possible. The government has to do something about the real problem that is the recession. The idle resources have to be employed. We cannot assume that bricklayers and concreters who lost their jobs can suddenly become biotech engineers on their own. I am sure there is a lot of things which can be built in the US. Yes it’s true that the bloated construction (and banking) sector may need to be shrunk but this will not be achieved by “creative destruction” but by creating new opportunities. “Creative destruction” only means that the global position of the US as the economic and technological leader is being steadily eroded. In 10-20 years time the Chinese will be the global leaders. USA will be a typical Latin American or Post-Soviet country with a narrow group of extremely rich tycoons and the masses lingering in poverty.
We had perestroika in the USSR the past, now we will have destroyka in the USA if the US Government and Congress refuse to run budget deficits accommodating the desires and needs of the non-government sector.
Adam take your reasoning one step further and you have the situation on one hand
“The net effect of “hoarding cash” visible at the aggregate level is not primary a result of lack of confidence. It is a result of debt deleveraging. This deleveraging might have been caused by loss of confidence and falling prices of real assets purchased during the phase A.”
And on the other hand
“Certainly desires of both groups of agents can be frustrated if austerity is introduced. “Patient” agents can be forced to spend and “impatient” may be forced to abandon repaying their debts – what obviously leads to defaults.
But it is up to the government sector to provide funds (not for “hoarding” but for repaying debt) if a depression is to be avoided”
Yet it is clear that simple government spending nor does not increase the amount of free cash that individuals have to pay down debt. Government spending is not a pay rise for the employed nor is it sufficient cash for the unemployed to afford to pay down debt.
Once interest rates hit zero what can the government do to so that individuals have more cash to pay down debt? The answer seems pretty clear….
many thanks for your blog. I note that your band has reformed, and will soon be playing gigs around Melbourne.
This is good news! I play mandolin in a country outfit. We play for ourselves, mainly, and don’t get time to do the kind of serious practise that would lead to live gigs. We are old guys with large families, and time for our music is, sadly, hard to come by.
On a different note, my wife and I were driving recently, listening to the radio, and we heard Natasha Mitchell, a local identity on the ABC, mention that her father is an economist. I did wonder if there’s a connection.
Anyway, always good to read your astute, engaging views on MMT.
Dear Micke (at 2011/07/07 at 10:53)
Thanks very much for your comments.
You should always make time for music and bands.
Natasha is my daughter.
“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.”
You need to consider the idea that the bond holders are counting on cutting Medicare, Medicaid, and Social Security to keep them satisfied and rates low.
The problem with debt in general (private and gov’t) is that it can used to “steal retirement”. That is what all the private mortgage debt was for, to get people to retire later or maybe even never at all. When that didn’t work, gov’t debt is/was used.
“You need to consider the idea that the bond holders are counting on cutting Medicare, Medicaid, and Social Security to keep them satisfied and rates low.”
That’s an appeal to superstition with no evidence behind it. Bonds are low in other sovereign countries with no plans on cutting anything.
We have enough fear tricks in play as it is which prevents anybody taking any action without inventing new ones.
About Medicare and Medicaid:
White House reportedly offers cuts to Medicaid, Medicare, in deficit talks
Administration Offers Health Care Cuts as Part of Budget Negotiations
Coburn, Lieberman seek to raise Medicare age to 67
“The plan the two men outlined includes a gradual increase over the next five years in the monthly premium that seniors pay for doctor and other non-hospital services. Aides said it would translate into a monthly increase of $15 to $20 initially.
The age of eligibility would rise gradually from 65 to 67.”
I am not sure whether you can claim that “Yet it is clear that simple government spending nor does not increase the amount of free cash that individuals have to pay down debt. Government spending is not a pay rise for the employed nor is it sufficient cash for the unemployed to afford to pay down debt. ”
I am convinced it is exactly the opposite. First of all the amount of cash (a stock) is not an issue here – nobody wants to give the debtors money to pay down the debt in one go. The amount of cash earned per unit of time ( a flow) is what really matters and the government is the only entity which can increase the size of that flow (if we exclude running significantly big current account surpluses).
Recession is a flow not a stock problem.
The issue is that a quantity of money is subtracted in each period (each unit of time) from spending and a lower dynamic equilibrium is reached by the system as a result. The accounting identities defining the relationship between C,S,I,G,T,X,M flows have to be met at all times. But they can be met at various levels of the dependent (endogenous) variables. Government spending and taxation are to some extent exogenous. In the short term X and M depend on the exchange rates. But beggar-thy-neighbour policy is not a solution to a global problem.
I disagree that the government cannot provide funds to keep repaying the private debt. Yes it can. In the absence of trade (or if I am to be pedantic – current account) surpluses only the government is able do inject spending (increase the demand). If there is a higher economic activity people will earn in a decent way money to service their debt – no moral hazard involved. This will also stabilise the prices of assets (homes) as there will be fewer foreclosures.
Imagine there is a construction company running at 50% of its capacity – wages are kept at the minimum level and some workers have been retrenched. Then the government steps in and pays for example for fixing up a crumbling bridge and a road full of potholes over a one year period. The money comes from the MMT black magic purse. Over the time needed to complete the project an additional flow increasing wages and profits over what was the previous short-term equilibrium value is provided. People directly involved and subcontractors can service their mortgages and buy new goods and services. The extra spending is multiplied by the spending multiplier in the economy as a whole. This determines the new short-term equilibrium of the system that is a state where boundary conditions imposed by the flow identities are met.
Even more dramatic effects on the aggregate demand can be expected if unemployed people are hired due to a Job Guarantee program as these people will either escape insolvency by servicing their debt or spend whatever their earn – they are very unlikely to save in the common sense (they have high marginal spending propensity).
Price of money is not the only parameter determining the level of capacity utilisation and GDP. High interest rates may slow down credit expansion in times of high demand. But lowering them to zero won’t help if there is a low demand for credit.
So the only way to escape the low deflationary dynamic equilibrium is to increase the current demand which will affect the expectations and planned investment through the volume of sales signal – or wait long enough for the debt deleveraging process and bankruptcies to take their natural course. However the system has hysteresis and some real opportunities will be inevitably lost during that period of time. The wealth of the society and the well-being of the significant number of people will be lower in the long run if debt deflation is not stopped on its tracks by the government.
Fed Up, your links are only evidence that politicians believe (or claim to believe) that what they are proposing will somehow be helpful, not that it actually will be. And, frankly, even if bond markets foolishly agree with those politicians, I’d be more concerned about the welfare of older, poored and sicker Americans than the bond markets, which could be taken out of the picture if necessary. But I tend to think that bond markets would be more focused on how productively we allocate real resources rather than how much we try to gut our already relatively modest social programs.
I mean, how is it that we can spend a trillion dollars blowing things up on the other side of the world, particularly without a well-defined and sensible goal, and still pay such low interest on our government bonds, but suddenly it becomes necessary to gut social security and public health insurance programs because we’ve reached an artificial debt limit?
If we could focus on creating value and ensuring a highly functional society, social programs would be least of our or anyone else’s worries.
Adam to suggest that all a business looks at in making investment, hiring or expansion decisions are “sales signals” is quintessential naive economics. Business will look at a range of factors including sales signals. Also most businesses have some built in flexibility with regards to varying output without varying head count. Just in time production particularly has quite a bit of up and down leeway in production capacity to cater for market fluctuations. So a spike in sales in a downturn will be rightfully viewed with caution by businesses.
Further by only looking at aggregates you would get erroneous view of what is happening underneath the aggregated numbers. The economy is divided into industries, sectors, businesses and staff etc. While government spending will make the aggregated numbers look healthy, the picture at lower levels can be quite different because the cash flows are not homogenous across the economy. Specifically workers tend not to receive pay rises in a downturn. So whilst government for example repairing a bridge will provide opportunity for a company to retain or hire some workers it does nothing for provide conditions for workers in secondary industries/ cash flows pathways to receive pay rises, (unless of course they are bankers or politicians who receive pay rises in all conditions) as no business is going to ignore the overall economic conditions.
The danger is clearly conflating the micro and macro pictures. If as we seem to agree there is widespread deleveraging occurring, then the average worker unless is in direct receipt of extra cash, will not be in a position to pay down debt without reducing some other spending. You can almost predict that until the underlying issues have been resolved, government spending will mask the underlying issues at an aggregated level, and once the spending stops the underlying issues will become evident again. Which seems to be exactly what we are seeing: low credit appetite, high unemployment suggests deleveraging is still well in progress. Let’s keep in mind too that while credit expansion creates new money, deleveraging destroys money, again obfuscating the overall aggregated picture. For the majority deleveraging is a slow process that government spending does nothing to accelerate unless it provides extra cash for workers, for example in the form of tax cuts.
The idea of job guarantees and employer of last resort are certainly worthy of serious examination.
I still believe the key in getting MMT across to people is in throwing a big fat light on central banking and the operational reality of how money ‘works’. You present this better than anyone else I’ve seen Bill. Great stuff !
“For the majority deleveraging is a slow process that government spending does nothing to accelerate unless it provides extra cash for workers, for example in the form of tax cuts.”
With your argument against business quantity expansion tax cuts would have no effect either. Any extra money freed up by develeraging would simply increase the amount hoarded by the profit share of the economy in the same way as if the money was spent directly. Businesses have been in cash hoarding mode since the turn of the millennium.
If the increase in the government deficit – by extra spending or tax cuts – just increases private sector cash hoarding in corporations, then I think you may have to use the threat of confiscation as a motivator.
Another stupid trend we’ve seen over the last ten years is to reduce corporate taxation rates and increase payroll taxes rather than increase corporate taxation allowances and reduce payroll taxes. Switching that around would move the burden from those that invest to those that hoard.
This has been Michael Hudson’s point for a long time. Encourage productive gain, discourage unproductive gain. Encourage flow and distribution, discourage stasis and concentration. To maintain flow at an optimal level systemically, government needs to tax and spend selectively in order to plug leaks and remove blocks and get the money “energy” to where it will be used productively.
@ andy I’ll take that challenge – i think i’m better at presenting a laymen explanation of MMT. You decide http://www.DollarMonopoly.com
You miss my point I think.
The layman or woman, in my experience, switch off about 10 seconds after you mention double-entry or balance sheets.
What will grab them and what Bill illustrates so well is the actual mechanics of government spending and financial asset/money creation. In the UK our central bank is also the ultimate settlement bank for payments. That effectively means that there is some guy at the BOE just moving numbers around a spreadsheet, consisting of columns for each member bank.
Thats it ! That is money being created, spent and destroyed. I think that image is a possible cure for the deficit hysteria we have in this country.
Good luck with the site. You have obviously put a lot of work into it and the more coverage of MMT the better in my view. Hopefully we are all after the same thing.
Andy – Absolutely, my challenge was in jest. I couldn’t remotely do or even try to do what Bill does. I agree with you whole heartedly with you on your second point. i’m in the process of doing another major rewrite. the balance sheet is definitely secondary to the overall message get across.
WHQ said: “Fed Up, your links are only evidence that politicians believe (or claim to believe) that what they are proposing will somehow be helpful, not that it actually will be.”
True, but that won’t stop them.
And, “And, frankly, even if bond markets foolishly agree with those politicians, I’d be more concerned about the welfare of older, poored and sicker Americans than the bond markets, which could be taken out of the picture if necessary.”
Most of the “people” running the bond markets don’t care about those other people. They only care about themselves. If necessary, sounds good. I want to see a zero private debt and zero public debt economy.
“But I tend to think that bond markets would be more focused on how productively we allocate real resources rather than how much we try to gut our already relatively modest social programs.”
It seems to me the rich who run the bond markets are only focused making sure almost all of the productivity gains and other things get allocated to themselves.
In an otherwise enlightening commentary on liquidity traps, you’ve made one large blunder. You claim: “In a true liquidity trap (a la Keynes) the demand for bonds evaporates because people fear capital losses.” This, of course, is patently false. For all riskless government bonds, longer term rates represent a series of overnight rates, plus a term premium. When short term rates hit their zero boundaries, longer term bond yields represent nothing more than term premium.
Under a “true Keynesian liquidity trap” if demand for bonds “evaporates” you are implicitly saying that the term premium will expand sharply. Why? When short rates are zero, term premium can be modeled as a call option on a higher interest rates in the future. (It is a call option, not a forward, because rates presumably cannot become negative to any significant degree.) What would make this implicit call option price rise to the stratosphere? It is both nonsensical and a misunderstanding of Keynes. Fear of capital loss is Bounded, not unlimited, once a central bank’s transmission mechanism is broken in an unconstrained nation.
Modern-day evidence from Japan shows that under liquidity trap conditions long term bond yields may go too low temporarily (the 10 year JGB yield hit 45bps in June 2003), and they will bounce back once this excess is corrected. But they will never go much above 2%.
Japan is indisputably in a Keynesian liquidity trap. Long term bond yields are presently 1.12%. If they rise anywhere near 2% while short term rates stay at zero, I will back up the truck and buy them. They will not go beyond that level until the government changes its ways (i.e., not anytime soon).
Kyoto – Japan
Kyoto – Japan
Sam, you said:
“Yet it is clear that simple government spending does not increase the amount of free cash that individuals have to pay down debt. Government spending is not a pay rise for the employed nor is it sufficient cash for the unemployed to afford to pay down debt.”
First of all, the unemployed will first spend the cash they get from the employment they obtain through by government spending on food, then they’ll catch up on their rent, and the landlord or will then spend that money. Following that, they’ll begin to pay down their other debts, whether you consider the amount they receive to be “sufficient” or not. After all, if they’ve been able to keep up the payments on their cars, they’ll try to keep them. Then there are the past-due utility bills, which they also will repay. Unfortunately, whatever money they devote to paying down most other debt in this climate is likely to just sit in the bank, doing nothing good, because the banks aren’t lending it out again. Nevertheless, they will spend money in productive ways, even if not all of it, and they will pay down their debts just so they can keep their cars (unfortunately, because banks were not allowed to go bankrupt and because their felonious mortgages weren’t restructured, the unemployed have already been thrown out of the homes they mortgaged, so that’s debt they don’t have to repay). As they repay their debts and spend on goods and services that they couldn’t afford before, demand will increase, prices will rise, and interest rates can be raised, thus making it profitable for banks to begin lending again.
Second, government spending will keep and has kept the already-employed employed. While most of them might not get raises immediately, some will. And they may even feel secure enough to take on more debt, don’t you think?
You deny that government spending would be used to pay down debt, and you say that it is “not clear” that would happen. You also assume that government spending would be insufficient to allow the newly employed to pay down any of their debt. Obviously, you are wrong both in your assumption and in the clarity of your conclusions. It is clear that people would spend the money they receive from government spending both on goods and services and to repay debt. The only question is how much benefit the economy derives from debt repayment versus what it gains from the additional consumer spending.
But some short considerations:
1) mainstream economics is the Keynes-Hicks-….-Blanchard tradition. What remains, it may be mainstream, but it is not economics.
2) QE had an impact (regardless of the liquidity trap), by avoiding mass deleveraging. Had QE an impact on the demand of government bond? Well, not directly -not by adding reserves (on this Krugman would agree)-, but look at the ECB and what happened when markets understood that Greece was thrown under the bus. If there is panic on bonds, the FED will buy bonds, so there can’t be panic.
3) The concept of liquidity trap is not necessary, it is more a tool for popularizing Keynesianism. The problem is (and was) a deflationary trap and, on this, MMT and most post-Keynesian may well agree. Even Schumpeter (is Schumpeter close to MMT?). What to do in order to avoid a deflationary spiral?
4) On Money Creation: the ECB experiment will probably support MMT, they are giving money to banks, banks will buy government bonds keeping interest rates low, but the government is cutting spending. Will it increase money supply or not? Will it avoid a domestic deflation in Europe (by the way, inflation minus tax increases minus nominal devaluation= deflation)? No.
5) I teach macroeconomics and I always start with the multiplier model. Students are at first caught by surprise, but, at the end of the course, it is still their preferred one.
6) In my opinion, there is an asymmetry related to open-market operations and in general in the efforts of the Central Banks to achieve the desired interest rate in different markets (bonds, equities, commercial paper). Moreover, if the animal spirits believe the Central Bank can influence interest rates, well, it will work on expectations. But again, MMT is not wrong, but Keynes -and mainstream economics as defined above neither!