Liquidity Trap: Theory And Practice

We get caught up in our theories.

Different disciplines have different categories of thought, different ways of looking at the world.  Different descriptions of the same thing, sometimes, not so much right or wrong but just …different.

So we were discussing liquidity traps and I was taken to school by some British economists, one who now teaches singing and another who is trying to unlearn what he has learned in economics because, among other things, the subject doesn’t describe reality very well.  In the Keynesian economics tradition the liquidity trap has a very technical if largely uninformative definition, so it’s a term of art.  And I misused the term from that standpoint, although apparently I have some good company (pdf).  I’ll concede, to some extent, but try to put this misuse in perspective.

One theory that we use to describe reality is evolution.  This is not the time to take on that subject in its entirety, just one aspect of it:  the idea of vestigial organs.  As the theory of evolution took hold in the latter part of the 19th century and the early part of the 20th the medical profession, owing to its observance of the scientific theory of evolution, came to the conclusion that human beings possessed a number of useless organs that had no function but were simply biological leftovers from a more primitive time.  Notable among these were the tonsils and the appendix.

Then, it was thought better that these organs be surgically removed, since they were just taking up space in the body and were prone to infection and so forth.  So convinced was the medical establishment of the soundness of this theory, children who had no difficulties often had their tonsils removed.  At the height of this insanity, probably about the 1930’s, medical teams would go to public schools and hold “tonsillectomy days“.  Sometimes mass surgeries were performed in the school gym.

Certainly there were many terms of art that applied to doing these surgeries and someone not trained as a doctor might very well misuse those terms in the course of discussing whether the surgeries should ever be done in the first place.  But in retrospect the important thing was to question the assumptions underlying the decision to do mass tonsillectomies.  Any misuse of the terms that were applied to the surgery itself would have been quite unimportant, comparatively speaking.  Such terms would have been a micro issue when the only genuinely important subject was the macro issue:  why are we even doing this at all?  The subject has changed, in other words, from questions about how the procedures are to be done to questions about the assumptions underlying the perceived need to do them in the first place.

One amusing aspect of our little digression over the term of art “liquidity trap” is that although it is regarded as an idea of Keynesian economics, Keynes himself did not use the term, at least not in the passage that is usually cited as originally describing the phenomenon in 1936:

…There is the possibility, for the reasons discussed above, 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. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

But let’s go a little deeper on Keynes.  He has the status of a high priest of the economics profession, and to say that he was the most influential economist of the 20th century would be an understatement.  By all accounts he was brilliant and witty and erudite.  People who disagreed with him strongly nevertheless thought highly of him on a personal level.

He made much of incorporating the principles of mathematics into economics, which is a “social science”.  This is historically odd, but very much in keeping with the intellectual trends of the era in which he lived.  The chief intellectual trend of this time – that is, the early 20th century – was logical positivism.  It was a particularly pervasive trend among British intellectuals like Bertrand Russell and AJ Ayer.

Without getting into too much detail about it, logical positivism would be fairly described as dogmatically empirical, and an intellectual argument for the supremacy of scientific method and inductive reasoning as opposed to what in earlier times might have been called pure reason, even though of course that is something akin to a contradiction in terms:  an intellectual argument that empiricism is superior to intellectual arguments.

In historical terms logical positivism was an inversion of centuries of western thought, in which empiricism was effectively subordinate to pure reason, but intellectuals had to come up with something to remain relevant when science, which had not been formally considered a higher intellectual pursuit up to that time, was quite literally dazzling the world with its many wonders.

So in the end John Maynard Keynes is really this:  the personification of the early  20th century’s most powerful intellectual fad – logical positivism – brought to bear upon the subject of economics.

A logical positivist must confine himself only to matters that are quantifiable, otherwise he is speaking nonsense.  This, at any rate, is the self conception of a logical positivist.  And it is this intellectual constraint that has led to such strange dogmas of modern economics as, for example, that debt is a neutral factor in economic analysis, because the net debt in an economy is always zero:  for every debt there is an asset of equal value in the hands of the creditor, so the two empirically cancel out.  In the quantifiable terms to which a positivist is confined, therefore, debt is meaningless.

Of course this is a profound error of economic thought, as well as being peculiarly empty in its descriptive power relative to the world around us, but let’s leave that for now.

When you go to your economics classes they apparently tell you that a liquidity trap is when interest rates are at or approach zero, such that monetary policy cannot stimulate the economy by lowering interest rates.  This can be readily agreed to, but what sort of situation is this?  Why would interest rates become zero bound?  To deal with these questions is to try to explain a liquidity trap rather than just identify an empirical fact:  namely that interest rates are at or near zero and aren’t accomplishing anything in the wider economy.

The Keynesian explanation for a liquidity trap is bizarre.  As Frances says:

Liquidity trap is when people hoard cash. It is a phenomenon of saving, not lending.

Well, even under the standard definition, a liquidity trap is not about saving or lending proper, but rather about interest rates.  Interest rates pertain to saving, but of course they also pertain to lending.

The reason I call the Keynesian notion bizarre is: why, when you can describe the phenomenon in terms of lending or savings, would you choose the latter and speculate – because it is speculation – that cash is being “hoarded”, when it is very easy to empirically ascertain levels of borrowing and lending, which is the flip side of the liquidity trap coin?  This is especially strange when one considers that Keynesian economics is grounded in dogmatic empiricism.

And the answer, I think, is that what underlies Keynesian economics is not  empiricism simpliciter, but rather empiricism infused with that other pervasive intellectual trend of the early 20th century:  Marxism.  It is Marxism’s fundamental hostility to traditional ideas of property, which of course can be perniciously “hoarded” rather than beneficially and socially utilized, that would change the focus of an otherwise pure empiricist away from empiricism into speculation; and its collectivist-socialist orientation that would discount or even ignore the role of debt saturation in causing a liquidity trap.  For the Marxist, debt is the unalterable condition of social man:  we are all in debt to each other, and to the society in which we live.

There is some truth in Marxism.  Some.  And like any other philosophy or theory, where it seems to help us understand reality, bravo.

But that’s not the case with respect to the Keynesian idea of a liquidity trap.  Frances again:

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.

Well, all right.  Just because there is a lack of lending and borrowing.  It is a lack of lending and borrowing in conjunction with zero bound interest rates that probably best defines a liquidity trap, and in practice that is best explained by – a debt deflation.  Quite obviously, you could in theory have zero bound interest rates and plenty of lending and borrowing of the “free” money.  This would not be a liquidity trap, would it?  Of course this may be theory only:  if interest rates are zero bound then lending and borrowing are likely to be problematic already.

Keynes himself apparently doubted that a liquidity trap could actually occur, but then like his followers he considered debt to be economically meaningless on a system wide basis.  The current situation exposes this as a fundamental error, because the theoretical liquidity trap has become real solely by virtue of a debt deflation, and if I am not mistaken there has never been another situation in which a liquidity trap has occurred in fact.

Thus in practice, debt deflation not only explains liquidity traps so far, it substantially defines them.

I agree that it is important to understand the idea of a liquidity trap so as to avoid errors of “policy” in addressing it.  The first step in understanding it is to become aware of the limits of Keynes and Keynesian economics.  Even though the idea may have originated there, Keynes seems to be curiously unhelpful in explaining it.