It isn’t just a theory. We’re in one. Have been since ’07.
From a comment I made over at NC, but here on my own blog I can provide links, which improve the explanation somewhat:
Personally, I think the liquidity trap is a real thing and that we’ve been in one since the subprime problems in ’07. And you could see it coming before that, too.
Keynes and MMT are the ones who fundamentally misunderstand the government’s relation to money. The proper role of government wrt to money is to define a monetary unit of account and adminstrate it through bureaus of weights and measures.
The liquidity trap occurs when all that has been disregarded, the unit of account becomes fiat, and the bulk of a nation’s money is created through lending to individuals and businesses. Without a reference point at the bottom of it all, new money issuance is deemed satisfactory so long as loans are being repaid on schedule. In fact this is the only criterion for monetary balance in such a monetary system. When that changes, and loans are no longer being repaid on schedule, lending constricts, and it cannot be otherwise. It doesn’t matter how much liquidity you supply to lenders, they can’t make loans because the borrowing capacity of the populace has dried up. They are debt saturated.
The only answer for this that Keynsians have come up with is for the government to act as borrower of last resort. But in that case government deficits explode and you wind up with Greece and the EU. With the UK and US not far behind.
In the system that we have, the fact that new money is loaned into existence is not discretionary. There is no other option. Thus if lending isn’t possible, no new money is possible either, and the money supply will stagnate or contract, which of course makes the repayment of existing outstanding loans more and more difficult.
This is why the “helicopter drop” remarks are intended to be funny. New money cannot be distributed that way. All newly created money must be owed back into the system; that is, someone must borrow it into existence and owe it back. It is the only way in a fiat system to regulate money issuance.
The subprime “crisis” signaled that the lending saturation point had been reached in the US. Since the country had largely run out of qualified borrowers, loans were made to UNqualified borrowers. There is no one to blame for this except the people who instituted the monetary system in the first place, and they’re all long since dead. The system will always wind up in this spot after a few generations.
The WaPo article discusses the common MMT inspired idea that taxes are the method for managing the government deficits that occur as the government becomes the borrower of last resort in a liquidity trap, which is just what is happening now. The idea being that the government takes back more and more of the new money that has been issued to ameliorate the deficit issue.
This is a frighteningly stupid assertion. It seems to contemplate a monetary circle jerk where new money is created through a loan to the government, paid out to whomever as salary or pursuant to a contract, and then the recipient is heavily taxed so as to get most of the money back. At that point, the monetary system is not reflecting or facilitating or serving the real economy, rather it’s the reverse: the real economy is serving the monetary system. To say that this is pointless and perverse is an understatement.
No theory of money and credit is worth a largely hungry and homeless populace, yet this is what is happening all over the globe: the theory is more precious than reality to those who get to make the decisions. We have government by so-called “technocrats” who are devoted to an idea rather than their subjects. And the idea itself is ridiculous.
The answer to all this is redeemable money that can exist and be newly issued apart from being loaned. But to get there from where we are will require a jubilee, because all the debt that has piled up cannot be paid back.
And it will take a constitutional amendment.
But this is a good thing. People need to recover their sense of self-government.
Update: With apologies to my British friends (see comments below) whose exchanges have really classed up the joint, if you know what I mean, I’m going to blame any confusion over what is meant by the term “liquidity trap” on Paul Krugman, like this guy does. And I’ll cite this guy, too.
And I do like the Queen.
Lawyers on Strike 
But that’s not the Keynsian definition of a liquidity trap. The Keynsian “liquidity trap” occurs when interest rates are so low that people see no point in putting their money into interest-bearing savings and prefer to hoard cash instead – stuffing mattresses etc. Keynes himself doubted that this would ever happen, and in practice it seems investors prefer to invest in “hard assets” such as precious metals and commodities in this situation.
What you describe is debt deflation, not a liquidity trap. You should read Irving Fisher’s “Debt Deflation Theory of Depressions”.
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I prefer not to be bound by Keynes’ definitions when they’re misleading or incomplete. Plus, there’s no real conflict between Keynes’ definition and mine, we’re just describing different aspects of the same phenomenon.
In any case, it’s not exactly debt deflation either, because in theory if the government acts boldly and quickly enough the ‘deflation’ problem will be solved, only to be replaced by enormous government deficits and oppressive and confiscatory taxation.
A trap is a trap is a trap.
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No, you are talking about two different things. The Keynsian definition isn’t to do with debt saturation, it is to do with saving preferences when interest rates are very low. Debt-saturated people don’t save, they pay off debt. Economically the effect is similar, in that they are not spending and money is being removed from circulation (or destroyed) so the money supply is falling. But the cause is entirely different and therefore the solution must be different as well. Failure to understand the difference between liquidity trap (paradox of thrift) and debt deflation leads to all manner of ineffective policies. People who are saving instead of spending can be encouraged to spend. It’s much more difficult to stop people paying off debt.
I don’t regard replacing one sort of debt with another as a solution.
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The term “liquidity trap” would refer to either situation. Liquidity is “trapped” with the lenders, and cannot get out into the economy because people and businesses are not borrowing. Whether that’s because they do not want to borrow, or because they are unable to borrow the result is a liquidity trap.
Lord Keynes described it in terms of the paradox of thrift, which is fine as far as it goes. But the liquidity trap phenomenon is the larger category. Debt deflation and the paradox of thrift are the sub-categories.
Is that fair?
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No, sorry, your definition is simply wrong. Liquidity trap is when people hoard cash. It is a phenomenon of saving, not lending. It may exist in conjunction with debt deflation, but the two are not the same and don’t have to occur together. Savings aren’t necessarily hoarded as cash when there is debt deflation. They may be invested in precious metals and commodities, as I suggested earlier.
http://en.wikipedia.org/wiki/Liquidity_trap
What the Keynsian liquidity trap DOES say is that when interest rates are at the lower bound, monetary policy alone cannot stimulate the economy and fiscal stimulus is necessary. In other words, QE is useless.
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Nobel Prize winner Paul Krugman and later text in that same wiki article agree with me:
You’ve got the phrase “proper exposition” going for you, though.
Truce?
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Can’t see how Krugman agrees with you. Doesn’t mention debt saturation. All he agrees with you on is that we’ve been in a liquidity trap since the financial crisis. That’s because monetary policy since then has kept interest rates at the lower bound, which means people have no reason to prefer interest-bearing savings over cash. Which is what I said.
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Krugman characterizes the US as being in a liquidity trap. Trust me, there is no hoarding of savings in the US.
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Krugman’s definition of a liquidity trap is interest rates at the zero bound making monetary policy ineffective – i.e. throwing cash at people doesn’t make them invest. Strictly this is the paradox of thrift, not a liquidity trap as such. However, there is certainly a preference for hoarding money in FDIC-insured bank accounts at low or even negative interest rates. I’d regard that as the equivalent of a liquidity trap where there is deposit insurance (remember when Keynes was writing there was no deposit insurance). Safe government debt is also trading at very low yields – again, a sign that people are hoarding rather than investing.
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I don’t disagree with that definition you ascribe to Krugman. Let me back up. “Defining” is not the same thing as “explaining”. The title of this post is Liquidity trap explained, not liquidity trap defined.
If I wish to define the “exhaustion requirement” for federal habeas corpus in the US, I can do so by saying that you must exhaust state remedies before seeking relief in a federal court under the habeas corpus statutes. A perfectly good definition, but it doesn’t explain very much to anyone who isn’t a lawyer in the US, or even to many who are.
To explain an idea, as opposed to merely defining a term, you do things like give examples. Or you may have to further unpack the words you are using to define the original term. I don’t think saying that a liquidity trap “…is interest rates at the zero bound making monetary policy ineffective” is terribly illuminating to people outside the economics profession, although it may be a perfectly good definition.
I am reminded of Wittgenstein.
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Unless I’m mistaken, you’re only half right here. You may have a paucity of borrowing and lending for reasons other than a debt deflation, but you could never have a debt deflation without a paucity of borrowing and lending. Correct?
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No. You are still incorrectly defining a liquidity trap as a lack of lending and borrowing. Lack of lending and borrowing is one of the signs of a liquidity trap but it does not define it. There may be a number of reasons for a lack of lending and borrowing of which a liquidity trap is only one. Debt deflation, credit crunch (when banks tighten lending standards) and high interest rates are all reasons for a lack of lending and borrowing but none of those is a liquidity trap. You can’t assume that just because there is a lack of lending and borrowing there must be a liquidity trap.
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What I’m trying to do there, Frances, is not use the term I’m attempting to define while I’m attempting to define it. Maybe this was wrong headed and generated more confusion than it alleviated.
But let’s not get bogged down. I’ll ask you to answer the question. And I’m going to go out on a limb and suggest the answer, as indeed you just did. There may be other causes for a lack of lending and borrowing, but a lack of lending and borrowing is always a feature of a liquidity trap. It is also always a feature of a debt deflation. A lack of lending and borrowing is therefore not just an incidental characteristic of these phenomenon, but a defining characteristic of them. And surely there is no error in saying that one feature – the lack of lending and borrowing – can be a defining characteristic of more than one and indeed distinct economic phenomena, like debt deflations and liquidity traps.
You could describe the same thing by saying that a liquidity trap is when monetary policy cannot affect the economy, because no matter how low you set interest rates people aren’t borrowing. That’s exactly what that wiki article says, and at least one thing that Krugman must mean if he’s saying that the US and the EU are in a liquidity trap. Japan may be a different story where indeed people are “hoarding” savings, which is the Keynesian idea, but that would not support your position as much as it would mine, which is kind of the reverse. Hoarding savings can be associated with a liquidity trap, but so can over-indebtedness. Japan can be in a liquidity trap for one reason, and the US for another, but both are in a liquidity trap.
And high interest rates would tend to indicate a demand for loans, would it not? So let me go out on another limb: you could never have a liquidity trap where you have high interest rates. In fact high interest rates are the opposite of a liquidity trap, because you can tap into the demand for loans by lowering rates, which is to say that you can affect the economy through monetary policy.
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You’ve changed your tune. Your post suggested that lack of lending and borrowing always meant there was a liquidity trap – that the DEFINITION of a liquidity trap was lack of lending and borrowing. I disputed this, because although lack of lending and borrowing is a feature of liquidity trap it is also a feature of other phenomena such as debt deflation which are NOT liquidity traps. Which is what you have now said.
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I thought you Brits were supposed to love “fair play”. I conceded, to some degree. Even wrote a long post about that. Now you’re beating me up again, after the towel has been thrown in.
But since you have stirred the pot again I’m going to retract my concession and pose to you a riddle, in the spirit of John Maynard Keynes himself.
You have defined a liquidity trap as the hoarding of cash, and your partner at Unlearning Economics stated that at its most basic level, a liquidity trap is the infinite demand for cash. I have stated that a liquidity trap is the absence of borrowing.
Here’s the riddle: explain why in a fiat money system the infinite demand for cash and the total absence of borrowing are the same thing, or at least the flip sides of the same coin.
It can be done in one sentence.
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I have to take issue with the assumption that all fiat currency systems must operate by “lending” money into existance. It is true that our current fiat system does just that, but the point of the MMT people is that borrowing into existence is unnecessary. The government could just create the money (no borrowing) and spend it into circulation (or issue it directly to the citizens) and through taxation remove it from circulation – thus maintaining demand for the currency and avoiding inflation.
Operating our money supply in this manner would improve our economic situation. I’m not sure it would fully fix things without making additional reforms, but it would remove the need for interest bearing debt behind the money supply.
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Hi Z.
We’re sort of at the nub of the problem. Nobody thinks that you can just issue money unconstrained by any criterion whatever, other than it being in someone’s estimation a good idea. The process of lending it into existence has a certain sense to it, because whoever borrows it must meet some requirements in doing so. As long as those requirements are applied consistently and across the board (they never are, but that’s another subject) it is a self regulating system and functions up to a point.
What is that point? As many others have pointed out, only the principal is created, never the interest. Interest on loans is heavily front loaded. Looking at the system as a whole, then, borrowers must scramble to obtain the money from others in the economy to pay back the lenders. This money is also originally only principal that was loaned to other borrowers. Someone – many others, potentially – must wind up short.
In addition, the money to pay back the loans will quickly evaporate unless there are new borrowers coming online to generate additional newly created money. Thus, the system depends upon an upward spiral of money creation through borrowing to keep going.
It’s a ponzi scheme of a type.
Notice that this dynamic is in place regardless of whether the banking system is public or private. It is not a function of that, but rather the lending at interest that causes the cycle.
Can the governmental authority simply distribute money, not as loans, into the economy by simply crediting people with it? Yes, in a manner of speaking. This is what Steve Keen is proposing as a “modern jubilee”, to re-balance things. But he proposes this as a one-off. The system could never actually function that way as a matter of routine, because no criteria are being applied to new money issuance other than what you might call political necessity, which is a function of political pressure. As a one off to address severe systemic imbalance that could feasibly be done, like the helicopter drop only appropriately directed. But this is a strictly political, or maybe legal act, not an economic one. Done to correct enormous economic distortions that have built up it might work after a fashion. Done all the time it would not correct distortions, but rather create them. Not to mention that money itself would be hideously politicized and centralized. No communist country even attempted that.
The need for money creation to be governed by some objective criterion other than people’s mere demand for it is basic and indispensable. You have to think about that. If demand is the only criterion, then he who demands the loudest is rewarded with money. This is not a formula for a just economic order; in fact it assures the opposite, where unrestrained and forceful self interest, plus a louder voice than anyone else’s, are the surest path to obtaining money.
In a commodity based monetary system objective criteria are provided by the natural scarcity of the commodity. In a fiat based system they are provided by tying money creation to lending, although the latter is unsustainable over time as we are seeing now.
But then abandoning objective criteria entirely, as Ellen Brown and greenbackers do, results in the tyranny of the obnoxious, loud, unproductive and spoiled.
The only thing left standing, then, is the commodity money approach. And it’s not a coincidence that this approach still has many adherents and the verdict of history behind it.
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Hmm. Commodity money systems have serious drawbacks too, not least of which being their inability to accommodate economic shocks. I’d suggest you read Eichengreen’s book “Golden Fetters” on the subject of the role of the Gold Standard in the Great Depression.
In the end, no system of money is foolproof. All systems depend on governments, banks, investors and borrowers acting responsibly. And to the extent that governments, banks, investors and borrowers fail to do this, all systems – however founded – tend to collapse under pressure. Exactly what form that collapse takes depends on the nature of the system: fiat currency systems tend to collapse in the form of asset bubbles and hyperinflation, commodity systems in debt crisis and depression.
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I made much the same observation about the drawbacks of fiat v. the drawbacks of gold here:
I don’t think “accommodating economic shocks” is a proper role for a money system. Economic shocks come and go and have exogenous causes, thus exogenous solutions, if any. Adjusting money itself in an attempt to alter or mute the underlying economic reality mixes up reality with the method used to gauge it. It’s like trying to solve a petrol supply crisis by changing the amount of petrol that constitutes a gallon.
I’m an economics luddite, I know, wedded to a barbarous relic.
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Haha. I wrote something exceedingly similar here.
http://coppolacomment.blogspot.com/2011/11/merits-of-debt-money-system.html
Came to a different conclusion, of course.
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The strategy of simply creating money as needed and removing it when not needed can be just as objective as any other sort of money creation.
From what I’ve read, the best way to determine how much additional money should be added to the economy is to take the cost of all goods and services available to end consumers and then subtract the total of all wages and other income received by end consumers. When positive, more money should be added to the system so that people can purchase all the goods and services in the economy. When negative, increased taxation or other methods of removal should be invoked to prevent inflation.
If the methods of accounting are open, honest, and fully transparent to everyone there should not be any complaints that there is too much or too little money in circulation.
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But what do you mean by “add money to the system”? Who gets it? Do they borrow it? Is it credited to them? On what basis?
As it stands now, “new” money goes to borrowers who presumably spend it but have to pay it back with interest. They give in exchange for the new money their promise to pay it back. In a gold system “new” money goes to gold producers. They have earned it upon receipt.
Who earns the new money in your scenario or at least gives something in exchange for it, even so much as a promise to pay it back?
Can giving something in exchange be dispensed with, so that people get money for nothing? Again, who? Everyone? Only those with a job? Same number of dollars to each, or proportionate to what they already have, or inversely proportionate to that?
Putting money into a system is not the same as getting it out in circulation where it can be spent. The Fed has put a lot of money into the “system” but it isn’t going anywhere and nothing is being done with it. I’d call that a liquidity trap again but I don’t want to further upset our dear friends across the pond.
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Ideally the government would spend it into circulation as it pays federal employee salaries, as it pays contractors who create and maintain our public infrastructure and also as it pays its various other bills.
Beyond that, extra money should be given directly to all citizens and residents of the country. After all, we are all part of the community of the United States and the money is being added to the system to help as many people as possible – to avoid bias it should be evenly divided amongst everyone.
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Right. So when imports are pouring into the country, we should simply create lots more money and give it to people so they can buy them all? Your definition of “goods and services available to end consumers” doesn’t exclude imports, after all. That would do wonders for the trade balance, wouldn’t it? China would cheer.
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As I understand it, that gap is currently met by people either borrowing more money into existance – or it’s not met and people just don’t purchase the goods and services (and also, employers refuse to hire).
But I must admit, I’m looking at our nation’s economy as a closed system – and it certainly isn’t. The world economy, however, is closed – we just don’t have jurisdiction over other nations. But if we were to implement such a plan, other nations may decide they no longer want to hold onto Federal Reserve Notes and demand either real goods and services or some other currency in exchange for their goods and services. If we choose to offer real goods and services rather than foreign currency, the trade balance will take care of itself.
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Zarepheth,
Your answer doesn’t answer my point. If the way to decide how much money to put into the economy is to add up all the things that end consumers could purchase, deduct from that the amount of money currently in circulation and issue the difference as new money, then there is no brake on imports. Instead of ramping up consumer debt you will debase the currency.
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Sorry but I have to agree with Frances that what you’re describing isn’t a Keynesian liquidity trap – you can’t simply redefine the term to be your own.
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I can’t disagree that I shouldn’t redefine someone else’s term to be my own. But, I didn’t title the post ” ‘Keynesian’ liquidity trap explained”. The liquidity trap link takes you to a page featuring Keynes, but the other uses of the term liquidity trap are discussed in the article.
If Krugman, the Nobel prize winner, can use the term that way, can’t I? Is this a restricted British proprietary term owing to Lord Keynes? Am I risking yet another British invasion due to my effrontery? If I say nice things about the Queen will you let me off the hook?
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Krugman does not use the term liquidity trap to mean lack of lending and borrowing, as you do. He uses the term in a similar way to Keynes – i.e. to define the limits of monetary policy – but without the restriction that the demand for money must be horizontal.
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At its most basic level a liquidity trap means an infinite (or very high) level of demand for cash, which isn’t what you are saying.
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I see what you mean, but I wouldn’t call it the “most basic level”. There’s a confusing intellectual error in there somewhere. The law of supply and demand should not be applied to money itself, at least not in that way. Money is not one desideratum competing against other desired goods and services, like washing machines and automobiles. It may be helpful to look at it that way sometimes and in some contexts, but not here.
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JMRJ I hate to accuse you of ignorance, as it’s something economists do a lot, but you don’t seem to understand Keynes’ theory of liquidity preference and the liquidity trap.
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Feel free to accuse me of ignorance, I have a thick skin. And not being an economist myself, I may indeed be guilty.
But it also may be that the theories are not capable of being understood because they are unintelligible.
I’ll pose the issue to you in the insightful manner you often refer to as you try to unlearn economics: is there any example in the real world of “…interest rates at the zero bound making monetary policy ineffective” other than the current one which is occurring in conjunction with a debt deflation?
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I get it. Picking the Flyshyte out of the pepper.
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Yours may be just as good an expression of the idea as mine. 🙂
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lending a debt is a debt is saving
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Good try, and you’re close, but not quite the answer I was looking for. Additional hint: in a fiat money system, what is money in is most irreducible aspect?
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JMRJ: “Here’s the riddle: explain why in a fiat money system the infinite demand for cash and the total absence of borrowing are the same thing, or at least the flip sides of the same coin.
“It can be done in one sentence.”
An infinite demand (sic!) for money means the total absence of lending, because the lender has an infinite desire to hang on to his money or, in the case of banks, has no desire to create money and lend it because the borrower, with an infinite desire to hang on to money, will not pay the loan back, and a total absence of lending means a total absence of borrowing.
Kind of a long sentence, but that is what you asked for. 🙂 The sic! is because there is no such thing as an infinite demand. Note also that an infinite demand implies an infinite desire, but not vice versa. 🙂
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Hmmm. Actually, with a fiat money system that may not be correct. Why? Because the government, not being a person (sick!), has no desire for money and no demand for it. Besides, as the source of money, the government has no demand for it, anyway. Therefore the government could create money and lend it out. So under a fiat money system there could be borrowing. (Before the American Revolution Pennsylvania created money by lending it out. Benjamin Franklin was a genius. 🙂 )
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I agree that Ben Franklin was a genius – I’m a Philly native, after all – but you’re getting colder here, not warmer.
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Nice try, but the answer has nothing to do with a borrower’s unwillingness to pay a loan back, but rather his unwillingness to take out a loan to begin with. That’s another hint.
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Excuse me, but how does an infinite demand for money translate into the unwillingness to take out a loan? A loan puts money in your hands, which, by assumption, you want to happen.
OC, there are paradoxes of the infinite here. An infinite demand for money means that nobody spends it. And that should mean that nobody wants it anymore, so there should be a zero demand for money, which is a contradiction. But then there are Yap stones and such. 😉
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You’re so close to solving the riddle that I think I’ll give it to you.
In a fiat money system, money in its most irreducible aspect is a claim of yours upon the efforts of others. A loan is the opposite: a claim by others on your efforts.
In one sentence then: An infinite demand for money is an infinite demand to a claim against the efforts of others, whereas zero demand for loans is an absolute refusal to incur any claim by others against you; thus they are essentially the same thing, in the sense that you cannot have the one without the other.
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First, the claim of the loan to an individual is less than that of the money, since the loan may not be repaid. To put it another way, with fiat money the claim of money is backed by the country, with a loan the claim is backed by the debtor.
But for the sake of argument let us suppose that the claim of the loan is infinite. If you lend me money, you may have a claim to an infinity of my effort, but I have a claim to an infinity of the efforts of everybody. And that includes you. Your net is infinity minus infinity, which is indeterminate. My net is also indeterminate. 🙂
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Keynes called it the “Paradox of Thrift”. If everyone wants to save, no-one can.
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Of course that wouldn’t be true where money was redeemable in a commodity. It is only true in a fiat money system.
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Billikin: quit while you’re ahead. You’re mixing up a lot of things together. The point I was making with the riddle does not involve things like the likelihood of repayment, or how many people back up a note. Also, the infinite “demand for money” would not be a claim by an individual for an infinity of the efforts of everyone; rather it would be an infinite demand collectively, but for each individual the demand would be for a claim quantifiable by however much money he demanded.
That’s probably not well put. I’ll try to think of a better way, but I probably declared a winner prematurely because you seem to misunderstand some aspects of the idea.
Then again, infinities and zeroes are not easy to work with, intellectually.
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JMRJ: “for each individual the demand would be for a claim quantifiable by however much money he demanded.”
Benjamin Franklin, in “A Modest Enquiry into the Nature
and Necessity of a Paper-Currency” ( http://etext.virginia.edu/users/brock/webdoc6.html) mentioned the time in recent memory when people worked for one silver penny per day. Increase the demand for money enough and people today would work for one aluminum penny per day. Increase it more and they would would for one penny per year. Increase it more and it would pay for the work of everyone on the globe for a year. Etc., etc. With an infinite demand for money, any amount of money, no matter how small, would command an infinite amount of work. One dollar would not command any more work than one cent. 🙂
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