The on-going crisis has nothing to do with a supposed liquidity trap

I was going to write about the so-called fiscal cliff today and would have shown that the only thing that might fall of the said cliff would be real GDP growth should the US Congress actually not extend the tax cuts and impose the spending cuts. The US economy would follow the lead from the British economy and double-dip in 2013 as sure as day follows night (or is it the other way round). The most elementary exposition of what we might call – ECO101 Macroeconomics – would tell us that. One person’s spending is another person’s income and so on. I note that some economists are arguing that ECO101 Macroeconomics is alive and well because it has had a an impeccable record in the current crisis. In my recent blogs – Fiscal austerity damages real growth and prolongs the financial downturn and Neo-liberalism has failed but we still don’t get it – I have argued that the mainstream of my profession has failed – both in anticipating the emerging crisis and providing credible solutions to remedy it. So have I overstated that claim, given that ECO101 Macroeconomics is the go-to approach at present? The problem is that while there are some leading economists who are arguing against harsh fiscal austerity at present at the basis of their reasoning is a thoroughly mainstream approach which has helped create the problem. I don’t think their version of ECO101 Macroeconomics provides the answers. There is some common ground with Modern Monetary Theory (MMT) but an even deeper incongruence.

Many readers of this blog have E-mailed me about my recent claims about “the mainstream macroeconomics paradigm has failed.” I have been told that economists such as Jonathan Portes and Paul Krugman (and others) consider mainstream macroeconomics to be the number 1 game in town. I obviously disagree but read or re-read the articles and blogs that I was referred to so that I could make a reasonable response.

The UK economists (and head of the NIESR), Jonathan Portes says he is a Keynesian because he believes that fiscal policy affects aggregate demand and that fiscal consolidation is a drag on the economy. But then he asserts that “pretty much everyone else whom one would take seriously” would also be a Keynesian in this sense.

In this article (February , 2012) – Fiscal policy: What does ‘Keynesian’ mean?, Jonathan Portes said that:

Nobody, and I mean nobody, really believes that it is impossible by definition for fiscal policy to affect aggregate demand.

Well it all depends on what one considers to be an “affect” – direction and size of impact, temporal period being considered etc. There are many who think fiscal policy has not short-run positive impacts. There are others who argue that fiscal policy might provide short-term boosts but in the long-run these disappear. There are others who claim that fiscal stimulus is always damaging.

Fiscal austerity is predicated on the view that, while short-term losses might be incurred (the most reasonable concede that) the medium- to long-term benefits are positive.

So there are lots of different views on this that divide the profession.

Rather curiously, given his previous remark, Jonathan Portes then (selectively) quoted from the 2010 UK Budget suggesting that the doctrine of ‘expansionary fiscal contraction’ had been embraced by the British Treasury. The quoted portion was:

These [the wider effects of fiscal consolidation] will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects.

He suggested that the “Treasury has not as far as I am aware repeated this argument, since the evidence shows precisely the opposite” and then argued that the Treasury had been debunked by bodies such as the IMF who he quoted as saying “Fiscal consolidation typically lowers growth in the short term”.

I have dealt with the folly of Ricardian equivalence extensively in a number of blogs – Pushing the fantasy barrow – Even the most simple facts contradict the neo-liberal arguments – Deficits should be cut in a recession and We are sorry.

But I found all that to-ing and fro-ing by Jonathan Portes to be rather curious because when I read the first Tory Budget delivered by the current Chancellor in June 2010 (just after the election), there was a section – Box 1.3 Economic impact of fiscal consolidation, in Chapter 1 – that said:

The overall economic impact of fiscal consolidation depends on the combination of:

• direct and indirect effects, from reduced public spending or increased taxation. These will tend to reduce demand growth in the short term; and
• wider economic effects, which depend on the reaction of the private sector and monetary policy to the changed fiscal environment. These will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects.

So that was where the Jonathan Portes quote came from. But it is clear that the British Treasury is saying that the direct and indirect effects of fiscal consolidation will be negative (in the short-term) and the “wider” effects (which include lower interest rates because the central bank has less fear of inflation; the confidence of the bond markets; and the impacts on private sector confidence) could deliver net benefits.

But if we read on further (in that Box 1.3) we find this assessment from the Treasury:

A simple comparison of the pre-Budget and Budget forecasts produced by the OBR suggests that fiscal consolidation will negatively affect the economy in the short term.

So the British Treasury didn’t say there would be net benefits arising from fiscal consolidation – rather, they left it as a possibility. It was the politicians who chose to massage that uncertainty and claim that fiscal consolidation would engender growth as a means of justifying their alarmingly irresponsible approach to fiscal management – which basically has pushed the British economy into a double-dip recession.

Jonathan Portes admits to changing his position since he worked at the British Treasury and that he no longer thinks:

… that fiscal policy never has any role to play in demand management, even though I don’t think it should be the tool of first resort.

Which then relates to his more recent blog – Macroeconomics: what is it good for? – which many people have E-mailed me about in relation to my blog – Neo-liberalism has failed but we still don’t get it.

To substantiate his apparent epiphany (since working in Treasury) – that is, to justify the view the mainstream ECO101 Macroeconomics remains relevant – Jonathan Portes chose to quote from Paul Krugman’s 2009 blog – Liquidity preference, loanable funds, and Niall Ferguson (wonkish):

So what does government borrowing do? It gives some of those excess savings a place to go – and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.

His own addition to that quote was to say that:

.. both the US and UK have had deficits running at historically extremely high levels, and long-term interest rates at historic lows: as Krugman has repeatedly pointed out, the (IS-LM) textbook has been spot on … So score one for macro 101.

So in their minds, the only reason that the increased budget deficits have not driven up interest rates is because the world is stuck in a liquidity trap.

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). But the distress will continue for a while. 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 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”. Jonathan Portes and Paul Krugman, basically fall into this camp.

They consider the present period to be a special case – the “liquidity trap” case – and argue that when an economy enters a liquidity trap monetary policy loses its capacity to influence aggregate demand and only fiscal policy (deficits) can be effective in reviving real GDP growth.

The first problem with this view is that the notion of saving is problematic. When individuals (households) save they postpone current consumption because they want to have higher future consumption. Saving is a time machine for non-government entities to allow them to transfer consumption across time. The obvious motivation is that they face a budget constraint – as users of the currency – and have to forgo consumption now if they want to save.

For the issuer of the currency – the sovereign government – there is no such financial constraint on spending. It does not have to forgo spending now to spend in the future. It can always spend what it desires at any point in time irrespective of what it did last period or any previous periods.

Further, when the government runs a budget surplus the purchasing power it extracts from the non-government sector doesn’t go anywhere – it is not stored in any account to use for later purposes. Just as a budget deficit (excess of spending over tax revenue) creates net financial assets (in the currency of issue) a budget surplus destroys net financial assets.

There is no store of purchasing power when the government runs a surplus nor does it make any sense for a government to think in those terms. It can always spend what it likes.

So it is nonsensical to characterise a budget surplus as being “saving”. It is more correctly described as the destruction of non-government purchasing power the non-government net financial assets.

Second, the idea that crowding out exists outside of a liquidity trap is also difficult to maintain once we examine how the monetary system actually operates.

At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

In most macroeconomics textbook, which is representative, we are taken back in time, to the theories that were prevalent before being destroyed by the intellectual advances provided in Keynes’ General Theory.

Whichever mainstream approach you like to choose (simple Mankiw type models of the loanable funds market or standard IS-LM models where the money supply is assumed to be exogenous and money demand driven by liquidity preference) you fall into the same errors of reasoning.

In Mankiw’s macroeconomics textbook, which is representative, we are taken back in time, to the theories that were prevalent before being destroyed by the intellectual advances provided in Keynes’ General Theory.

Most ECO101 mainstream approach assumes that it is reasonable to represent the financial system as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”

The loanable funds doctrine (first developed by Wicksell) was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.

So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

This approach also characterises budget surpluses as being part of “national saving” so that budget deficits are cast as drawing down national savings – and specifically, using private savings (via government borrowing).

The logic used to argue that (in normal times) budget deficits drive up interest rates and choke off growth is as follows: national saving is the source of loanable funds and is composed (allegedly) of the sum of private and public saving. A rising budget deficit reduces public saving and available national saving.

As Mankiw says in his textbook:

The fall in investment because of the government borrowing is called crowding out …That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment. Thus, the most basic lesson about budget deficits … When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.

This is the ECO101 Macroeconomics viewpoint. Both Jonathan Portes and Paul Krugman would subscribe to that view – as a normality (outside of their claimed liquidity trap).

That is why they also advocate zero or negative structural budget balances.

On August 24, 2011, Jonathan Portes wrote – The coalition’s confidence trick – and argued that:

No serious economist disagreed with the proposition that the deficit needed to be brought down very substantially over time, and that it was sensible to aim to eliminate the structural current deficit.

No serious Modern Monetary Theory (MMT) economist would ever agree with that statement. We would never say that the “structural” (that is, non-cyclical part) deficit should be eliminated as a matter of course. It all depends on what is happening in the other sectors.

For example, if the external sector is in deficit, then eliminating a structural deficit would, when measured at full capacity, be equivalent to forcing the private domestic sector to run deficits, at least as large as the external deficit. In other words, growth would only be coming from ever-increasing levels of private sector debt.

The probability of getting to full capacity under that strategy and staying there for very long is very low to zero. If the current crisis has taught us anything it is that nations cannot sustain growth for very long on the back of ever-increasing levels of private debt.

But in terms of the crowding out argument, there are several points to make.

As noted above – budget surpluses are not even remotely like private saving. You should clearly understand by now that budget surpluses destroy liquidity in the non-government sector (by destroying net financial assets held by that sector). They squeeze the capacity of the non-government sector to spend and save. If there are no other behavioural changes in the economy to accompany the pursuit of budget surpluses, then income adjustments (as aggregate demand falls) wipe out non-government saving.

The crowding out models assume that there is a finite pool of saving that is drawn on by competing borrowers including the government and it is the interest rate that adjusts to ration any excess demand for “funds” (saving balances).

MMT does not claim that central bank interest rate hikes are not possible when a government is running a deficit. It is possible that a central bank will interpret a rising budget deficit as being inflationary and push up interest rates. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.

Of-course, MMT considers that the aggregate demand impact of interest rate rises are unclear and may not even be negative depending on rather complex distributional factors. Remember that rising interest rates represent both a cost and a benefit depending on which side of the equation you are on. Interest rate changes also influence aggregate demand – if at all – in an indirect fashion whereas government spending injects spending immediately into the economy.

This is the reason why MMT proponents do not give priority to monetary policy over fiscal policy.

But the crowding out theories taught in ECO101 Macroeconomics are not based on these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending. This is what is taught under the heading “financial crowding out”.

A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply. Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market. This is the Bastard Keynesian approach to financial crowding out. Please read my blog – Those bad Keynesians are to blame – for more discussion on this point.

But these models misconstrue the way the monetary system operates and, in particular, the way the banking system works. Please read the following blogs – Money multiplier and other myths – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

From a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. The funds used to buy the government bonds come from the government!

There is just an exchange of bank reserves for bonds – and so there is no net change in financial assets involved.

There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”.

A basic fact that any ECO101 Macroeconomics student has to understand is that saving grows with income (being the macro residual left after consumption decisions have been taken).

In 1931, as part of his demolition of the then British Treasury View (that eschewed budget deficits), Richard Kahn, who had studied under Keynes noted that total saving is a function of national income and so there is no fixed pool of saving over time unless we believe that income can never change.

As disposable income rises, consumption rises and along with it national saving because households, in aggregate, tend not to spend all their disposable income. The initial injection of spending spurs the expenditure multiplier process which continues adding to demand and output until the extra consumption (after each successive round) is zero. What we observe is that the final increase in national saving is exactly equal to the initial increase in spending (whether it be a public spending injection or an increase in private investment).

The loanable funds doctrine posited that prior saving generated investment. But Kahn showed categorically that it is total investment (or total spending more generally) that determines total saving not the other way around. This point demolished the “loanable funds theory” that underpins the crowding out claims. Much later, the Italian economist Luigi Pasinetti noted in one of his articles that “investment spending brings forth its own saving”.

This was the basis of the belief by Lloyd George that “a budget deficit finances itself”. But importantly, deficit spending generates income growth which generates higher saving.

It is this way that MMT argues that deficit spending supports or “finances” private saving not the other way around.

Please read my blog – We can conquer unemployment – for more discussion on this point.

Finally, what about the liquidity trap argument? I have covered this argument in depth in this blog – Whether there is a liquidity trap or not is irrelevant. You should read that blog if you want a detailed analysis of the concept and an MMT critique.

Economists such as Jonathan Portes and Paul Krugman would suggest they were part of a long tradition starting with Keynes when they suggest that fiscal policy stimulus is safe (and essential) in a deep recession when the economy is mired in a liquidity trap.

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 also 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.

The essential argument was that people have various motives for holding cash (against other forms of financial wealth which is less liquid). One such motive – the Speculative-motive – was “particularly important in transmitting the effects of a change in the quantity of money”.

This was the entree in to the concept of the liquidity trap. Keynes suggested that people will hold more cash when interest rates are lower and vice versa.

The normal liquidity management operations of central banks include so-called “open market operations” where the bank buys and sells government bonds to manipulate bank reserves and manage the short-term interest rate, although in the standard macroeconomics textbooks, students (erroneously) learn this is about controlling the “money supply”.

In the previously cited blog – Whether there is a liquidity trap or not is irrelevant – I show how 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.

In an oft-quoted passage from Chapter 15 (Section III), Keynes argued that:

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.

This is the liquidity trap – and 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.

As a result, 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.

This concept was further developed by 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 IS-LM model that is standard fare for intermediate macroeconomics students.

In this model, the normal state is for monetary policy changes (erroneously considered to be controlled by the central bank) impact on interest rates and, in turn, the real economy (via interest-sensitive components of spending). But when the economy hits a liquidity trap – that is, when everyone forms the view that interest rates can only go up – this capacity is lost and fiscal policy is the only way for government to alter real output.

There are two ways in which the Hicksian approach 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, a more modern approach by mainstream economists suggests that the way monetary policy works is via its influence on the volume of funds available by banks for credit. The modern version of this relates to the debate surrounding quantitative easing.

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.

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.

They also argue that in the medium- to long-term budget deficits undermine private spending because they drive up interest rates. But in this special case – they are safe – for a time.

That is the position that economists such as Jonathan Portes and Paul Krugman regularly represent.

As an aside, in a true liquidity trap (a la Keynes) the demand for bonds evaporates because people fear capital losses. So the current situation is not of that ilk because the demand for government debt (among the currency-issuers) is very strong and yields are correspondingly low.

None of this has any traction from the MMT perspective.

First, the narrative that says that monetary policy is effective outside of a liquidity trap and powerless during a trap is highly questionable for reasons explained above – the distributional arguments.

Second, 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 at present even with interest rates low and in some cases negative. 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.

Third, what about this idea that the liquidity trap occurs when cash and bonds are near substitutes so people are indifferent between them? This is the modern version of the liquidity trap but 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.

Conclusion

The liquidity trap is a ruse to rationalise why the normal ECO101 Macroeconomics model failed to predict the crisis and has allowed irrational claims that the rising budget deficits would cause rising inflation, interest rates and debt defaults to persist.

The reality is that 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. The persistent unemployment is caused by budget deficits that are too low.

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.

I maintain my position that students are not taught to understand the way the monetary economy operates when they undertake a typical ECO101 Macroeconomics course and extend that study into ECO201 Macroeconomics (where they might encounter IS-LM analysis).

Simulating the Job Guarantee

My colleague Scott Fullwiler has produced an excellent simulation – Job Guarantee.

My only comment was represented in this tweet I sent Scott:

@stf18 At present there are 100 dogs and only 92 bones in the US and 75 in Greece and Spain! – nice JG sim though [link as above provided]

The reference to the dogs and bones can be understood if you go to this blog – Even the most simple facts contradict the neo-liberal arguments – and head down the screen to the included Case study: the parable of 100 dogs and 95 bones

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.