Philip Pilkington: Paul Krugman Does Not Understand the Liquidity Trap

Philip Pilkington is a London-based economist and member of the Political Economy Research Group at Kingston University. He runs the blog Fixing the Economists

liquidity trap image

I came across a very amusing piece from Krugman in 2010. The piece is entitled ‘Nobody Understands the Liquidity Trap‘. Actually, Krugman might have a point — if we include him in the ‘everybody’ that does not understand the liquidity trap and thus conclude that he, and all those that listen to him, do not understand the liquidity trap.

You see Krugman confuses the zero-lower bound for the liquidity trap. But in doing so he completely scrambles the meaning of the term ‘liquidity trap’.

Let us first get a feel for meaning of the term ‘liquidity trap’. Here is Keynes in the original. In the General Theory he writes:

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.

So, a liquidity trap is a situation when the central bank pumps in money and the rate of interest doesn’t respond. People say: “Meh, I don’t like the look of those bonds, I’ll just hold this cash”, and so bond prices remain high.

Krugman, on the other hand, has completely confused two concepts — that of a zero-lower bound scenario and a liquidity trap. You can see this clearly in his 1998 paper where he writes:

A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. (p141)

Um, no. A liquidity trap is when people say “nah, I don’t want bonds, I want money”. It is a situation in which the rate of interest on bonds do not respond to an increase in base money. Let us be clear: in a liquidity trap people do not want to hold bonds. In a liquidity trap cautious investors spit bonds back onto the market, their prices fall and their yields rise.

It is thus obvious that a liquidity trap occurs when the rate of interest gets ‘stuck’ and does not respond to an increase in base money. As I have argued before, we saw this in 2009-2010 when interest rates on risky assets failed to respond to Fed intervention. But we do not see this today. The central bank have not today, as Keynes puts it, “lost control over the rate of interest”. After 2009 interest rates came down across the board in response to actions by the central bank. Today it is well-known to even the most myopic mainstream economist that we live in a low yield environment.

What we do see is a zero interest rate. But that is just a zero interest rate. It is not a liquidity trap. We know this because bonds are still very much so in demand. Whereas in a liquidity trap people want to hold money instead of bonds. That is not the case today. Today people are desperate to get their hands on bonds because holding money is eroding their portfolios due to the substantial negative yield being incurred. But in a liquidity trap, as Keynes says, “almost everyone prefers cash to holding a debt”.

Let’s just get that straight: the key symptom that indicates that there is a liquidity trap is that people want to hold cash instead of bonds. Let me state that one more time in a different way: a liquidity trap is when there is a panic across financial markets, people rush to cash and no matter how much cash the central bank issues the demand for financial assets remains depressed.

Last week Janet Yellen said that she was concerned that people were too eager to hold junk bonds. And here are Krugman and the New Keynesian brigade telling us we’re in a liquidity trap. It is completely absurd. What has occurred is that monetary policy has failed to revive the economy. That’s a sad day for mainstream economists who have believed for over three decades that monetary policy is a panacea. But it is still not a ‘liquidity trap’. That term has a specific meaning. It is useful. Equating it with the central bank setting the interest rate near zero is equivalent to destroying the term and sucking it of its meaning.

It gets worse when you think this through in more detail. Recall that for Keynes a liquidity trap is when “the monetary authority would have lost effective control over the rate of interest”. But have the monetary authorities lost control over the rate of interest at the zero bound level? Nope. Anyone who has actually read Keynes’ great work knows that in it he discusses Silvio Gesell’s ‘stamped money’ which would be an obvious way for the monetary authorities to impose negative interest rates of their choosing. Keynes writes:

According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure.

(There are quite a few variations on this idea some of which I’ve noted before — although I’m not very enamored with the idea).

So even by the simple criteria of whether the monetary authorities have lost control over the interest rate it is obvious to any reader of the General Theory that they have not. No liquidity trap here folks!

Now, I know the response to this. “Ugh! You read too many books Phil! Reading books is for humanities students! I’m an economist, I do maths and stuff and I’m a really super serious sort of person that only cares about economic theorising, I don’t care what Keynes said or what other books say, I only care about Science,” says our typical mainstream economist.

Well, this is the thing: the actual concept of a liquidity trap is a very useful tool when applied to understanding financial markets; especially when they go into meltdown. Minsky, for example, uses it at critical points in his work. Meanwhile the Krugmanians deploy it as a fancy sounding word for what is a simple and banal concept: zero interest rates. They use it to give authority to the fact that their economic theory today ultimately says “the Fed can’t lower interest rates past zero therefore we cannot rely on them to revive the economy” which is so flagrantly obvious a monkey could have come up with it — indeed, those who have read Chapter 23 of the General Theory  on stamped money know that this statement is not even true and that our simian pal would be wrong.

“Hey, I want to hide the fact that I’m saying something banal so I’m going to use this fancy-sounding word that is in Keynes and is related to the ISLM,” say the Krugmanians. I’m saying rather that we should define the concept of liquidity trap properly because it is a useful and interesting analytical tool, especially when trying to understand what happens in a crisis scenario when the demand for cash really rockets and the monetary authorities really do find that they have lost control over the price of financial assets (and, hence, interest rates).

Which usage is closer to a ‘scientific’ usage. Well, only you, dear reader, can decide that. But that decision will likely be informed by how good an understanding you have of actual financial markets and how they affect the macroeconomy. Let’s just say that economists like Minsky are a better guide than people hocking the ISLM, easily the crudest tool ever invented by a Keynesian monetary economist (Hicks himself, who became quite a good monetary economist after that particular car crash, later basically said this lest we need be reminded).

If you want to understand nothing about financial markets read Krugman and play with the ISLM, if you actually want to understand how financial markets work read Keynes, read Minsky, read Harrod, read Robinson — hell, read Hicks’ more advanced work on money and financial markets. Oh, but then you might have to open a book and actually read it rather than twisting clearly defined concepts to cover up the fact that you’re basically saying nothing beyond the fact that central banks have near zero interest rates. Terrifying prospect.

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60 comments

  1. John

    Krugman is so high profile…. he’s always under withering scrutiny. The point is: economists get it wrong so often, why do they still have strong followings and enjoy decent incomes from seriously bad advice? No other industry could survive under similar circumstances. They would be run out of town and sent to the poor house and to never to return.

    Economics is also a sector where arguments are taken as consensus — near 100% expert acknowledgement — while the opposite is true. A hand bag size of it is consensus. These high-priests have the credentials to write anything and get away with it because they have the full faith backing of brigades of other economists when attacked for spreading false guidance. How dare we mere mortals challenge them?

    1. GlassHammer

      “The point is: economists get it wrong so often, why do they still have strong followings and enjoy decent incomes from seriously bad advice?”

      Because those that want “bad public policy” need “bad economic advice”.

      The law of ill-intended consequences is quite real.

    2. Art Eclectic

      Old saying
      “The only function of economic forecasting is to make astrology look respectable.”

      Other industries that seem to survive on irrational and bad advice: Astrology, Fortune Telling, Seances, and 401k Portfolio Management.

    3. Oregoncharles

      Soothsayers used to do really well, too. Even the pretense – even the KNOWN pretense – of understanding the futures is worth real money.
      Especially when they’re also useful propagandists for the plutocracy, in practice their main job.

    4. David

      I think the more important trap is where the markets need the ongoing liquidity produced by central bank easy money. If the central banks withdraw the easy money, the markets start to drop, so the easy money continues. At what point can the central banks withdraw easy money without causing a financial downturn? We’ll soon see ;)

      http://canonicalthoughts.blogspot.com

  2. Bobbo

    Not defending Krugman, but I’m skeptical of any debate over definitions. Isn’t this just another situation where people define terms differently? Is there a standard textbook definition of a liquidity trap?

    businessdictionary.com: “Situation where bank cash-holdings are rising and banks cannot find sufficient number of qualified borrowers even at extraordinary low rates of interest. It usually arises where people are not buying and firms are not borrowing (for inventory or plant and equipment) because economic prospects look dim, investors are not investing because expected returns from investments are low, and/or a recession is beginning. People and businesses hold on to their cash and thus get trapped in a self-fulfilling prophecy.”

    investopedia: “Liquidity Trap. A situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.”

    about.com: “The Liquidity trap is a Keynesian idea. When expected returns from investments in securities or real plant and equipment are low, investment falls, a recession begins, and cash holdings in banks rise. People and businesses then continue to hold cash because they expect spending and investment to be low. This is a self-fulfilling trap.”

    Economic Times: “Liquidity trap is a situation when expansionary monetary policy (increase in money supply) does not increase the interest rate, income and hence does not stimulate economic growth.”

    qfinance.com: “a central bank’s inability to lower interest rates once investors believe rates can go no lower.”

    1. Ben Johannson

      The problem is that Krugman advertises himself as a Keynesian, yet often appears to have never read anything by the man.

      1. larry

        Ben, K’s written an introduction to a recent edition of the General Theory. But you can tell he either didn’t read it carefully or didn’t understand it when you read his comments on where Keynes went wrong. I am not saying Keynes didn’t make mistakes; I am saying Krugman doesn’t understand what they are.

    2. diptherio

      Honestly, I think this just shows all the fuzzy thinking out there. Let’s go through them:

      bussinessdictionary:

      Situation where bank cash-holdings are rising and banks cannot find sufficient number of qualified borrowers even at extraordinary low rates of interest. It usually arises where people are not buying and firms are not borrowing (for inventory or plant and equipment) because economic prospects look dim, investors are not investing because expected returns from investments are low, and/or a recession is beginning.

      Well there are plenty of borrowers, right? They’re just all speculators. People are definitely investing, else why the record setting closes on the Dow? More and more money seems to be pouring into the market (although it’s not being invested in anything real or physical) and expected returns from investments are up, no? Isn’t that why my pops’ investment advisor just moved him out of bonds and into stocks, ’cause stock returns are looking up and bond yields are in the cellar? So we’re definitely not in a liquidity trap by this definition.

      investopedia:

      In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise.

      Again, not by a longshot. As Yellen is yellin’ about, people are waaay into junk bonds at the moment (see Cynk Inc). So no liquidity trap by this definition either.

      about.com:

      When expected returns from investments in securities or real plant and equipment are low, investment falls, a recession begins, and cash holdings in banks rise.

      Expected returns for some securities are up, and overall investment (if we count investment in Cynk and other imaginary entities) is up. Junk bonds are selling like hotcakes. If we’re in a liquidity trap, it isn’t the type about.com has in mind.

      Economic Times:

      Liquidity trap is a situation when expansionary monetary policy (increase in money supply) does not increase the interest rate…

      Oh my…expansionary monetary policy is synonymous with low interest rates…there is no reason to ever expect expansionary monetary policy to increase interest rates. These guys are even more confused than Krugman.

      And finally qfinances’ short-and-sweet: “a central bank’s inability to lower interest rates once investors believe rates can go no lower.”

      As pointed out in the article, there are plenty of ways for a central bank to lower interest rates even into negative territory, if they so choose. This definition is meaningless.

      Pilkington is right: the concept of a liquidity trap is an interesting and useful one, but it’s not what we have now and it’s not what Kruggy, seems to think it is.

      1. fresno dan

        diptherio
        July 23, 2014 at 12:32 pm

        Nice job of pointing out the contradictions. I wish the article had been clearer on the zero lower bound, and also exactly why a negative real interest rate is suppose to get us out of our malaise (yes, I understand that it makes borrowing cheaper, but at least for me, even if I could borrow 10K for free I wouldn’t do it, cause I would still have to pay it back. If I could borrow at negative interest rates and get 4%, which is far, far more than my saving account, I would borrow, not buy anything, and just collect interest, and than pay back the loan. So I don’t see how this actually works to stimulate economic activity….)

        By the way, these are just questions that just come to mind, and not specifically for Diptherio. I am just curious on what answers people would provide. Thanks

        1. Am I interpreting Keynes correctly that Keynes meant by a liquidity trap that people did not want to hold FINANCIAL INSTRUMENTS – e.g., stocks, bonds, and even saving passbooks – they wanted the cash in their grubby hands (which I assume is out of the fear that the institution holding them or backing them did not have the assets (or cash) to actually redeem them?)
        2. If that is the case as described in 1 above, than it is correct that interest rates are not particularly relevant to what is called a “liquidity trap”?
        3.If it is universally agreed that there isn’t enough borrowing, how much would be enough?
        http://research.stlouisfed.org/fred2/series/TOTALNS
        http://research.stlouisfed.org/fred2/series/FGTCMDODNS
        http://research.stlouisfed.org/fred2/series/FYGFDPUB
        3.a. If there a formula or historic record of rate of borrowing and GDP? (link is possible)
        4. Are the links under 3 a good overall picture of borrowing in the US?
        5. If the links above are not a good overall picture, is there a better link?
        6. Of course, borrowing isn’t a static thing. Is there a typical RATE of borrowing that is equated with a healthy economy and a rate associated with a recession (bearing in mind the unusual boom and bust cycles of the last 20 years)? and of course, is there a link to that.
        7. I am always curious about the emphasis on borrowed money, debt, and interest rates. And yet, income never gets talked about. I am not understanding how the debts are supposed to be paid if the income for the median is falling? Is there a rational why income is not particularly important (the riff raff never have enough income to pay their debts, and their income is such a small percentage of the national wealth so no need to worry about them)?
        http://research.stlouisfed.org/fred2/series/MEHOINUSA672N

        8. Which begs another question – – economists love their aggregated data, but the 0.01% could be doing 90% of the borrowing (I don’t know which income quintiles do most of the borrowing). Some economists like to say every debt is somebody else’s asset. So does it matter who is doing the borrowing? (yeah, I’m aware of the housing collapse – for the sake of this question I presume normal default rates). Is there a typical distribution of borrowing across income quintiles that is associated with a healthy economy?

        1. Ben Johannson

          In response to #1 Keynes argued that investors may not want to hold bonds if A) their yield was not better than cash and B) they expect yield to rise in the future. So you’ve got it right.

        2. Ben Johannson

          Re #2

          Ok, I might have misunderstood your question #1: Yes, the interest rate matters. Psychology and uncertainty about the future are really in control when we discuss a Keynesian liquidity trap. If I’m an investor and I expect bond yields to drop, I buy before that happens and then can trade them for a premium when everyone else is left with lower yielding bonds. But if yields on bonds are already so low they don’t really give me a return better than cash (in my example cash refers to bank reserves, which currently pay a return of 0.25%), and I expect yields to rise in the near-future then there’s no way I will buy before that happens. If I were to buy at a low yield and then new issuances of bonds see a higher yield, then my bonds lose value relative to those higher-yielding bonds issued later.

          Today there’s much less uncertainty about this sort of thing because the Fed follows a “forward guidance” policy where it telegraphs changes in things like the short-term interest rate, supposedly to reduce market volatility. Treasury yields follow the short-term rate and because government bonds and the Fed are the biggest players in the game, yields on other securities are dragged along.

    3. Paul Tioxon

      The problem with this critique, that we have not set our definitions of the term to be consistent one another, is that we are looking for valid knowledge, based on more than our ability to communicate terms. Lamarckian Evolutionary theory and Darwinism are both evolutionary theories, but only one has turned out valid. And, it not a failure of communication, but a failure of one definition to be a sound idea for explaining relevant events. Keynes says liquidity is a preference for holding cash. As to why holding cash is good idea, may vary. But whatever the cause, when a large enough group of people start holding a large enough amount of cash, the amount of money circulation in the economy, for whatever purpose, consumption or investment, goes down getting us stuck at some point in a trap. People anticipating a war may have a liquidity preference that may be for purposes completely at odds with ZIRP, as Keynes witnessed first hand. Planning for a stable world where progress spread outwards to the horizon as far as the eye can see and interest rates could be anticipated as more problematic than the invasion of you country creates liquidity for an entirely different category of reasons. I think it is important to remember why Keynes wrote a general theory and spoke of a liquidity trap as a general problem, and not to tie it as consequence of central bank interest rate policy or not. People fleeing Nazi Germany had a liquidity preference for purposes of migration out of Germany. Liquidity preference and the trap that could result at some critical point does not depend on this or that reason why people are rushing into cash, only that they are and that this phenomena needs to be addressed for the trap it can lead to.

      1. financial matters

        Yes, definitions can be important, I see interest rates, including those on Baa corporate bonds as being one measure of economic health but probably an imperfect one compared to employment and income inequality. It seems that in a broader sense Keynes was talking about a liquidity trap as being a failure of monetary policy (basically interest rates and quantity of money) in being able to stimulate a healthy economy.

        I think he was talking about the situation we’re in now in that this low interest rate environment isn’t creating economic health and we need a non-austerity fiscal package addressing issues including employment and income inequality.

        1. jonboinAR

          It’s been seeming to me through this whole thing that we could have used some good old fashioned protectionism.

  3. financial matters

    I think a similar way to view a liquidity trap is in terms of the quantitative theory of money. As you mention low interest rates are stimulating speculative activity but not by themselves stimulating the real economy.

    I liked Randy Wray’s discussion of a liquidity trap. He describes it from a somewhat different angle and in terms of what he thinks was the essence of Keynes thinking on the matter.

    He describes it as ‘marginal efficiency of capital’ or easiest for me to understand ‘profit expectations’ which can actually turn negative making producers not want to invest in production as there are not enough people to buy their product (demand) so they would lose their money. (negative profit). The variable is not interest rates but profit expectations.

    I like this reframing of a ‘liquidity trap’ as a ‘demand trap’. Even if several million dollars are available at low interest producers aren’t going to put that money into production unless there are enough employed people to buy the product. And this takes fiscal policy that is stimulative rather than promoting austerity.

    Some companies are starting to understand that federal deficits can correlate positively with company profits. The key is for these deficits to stimulate real demand rather than try and stimulate borrowing using the confidence fairy.

    http://ec.libsyn.com/p/f/2/4/f2401393fdd5ef47/Podcast_with_Randy_Wray_Sept_23.mp3?d13a76d516d9dec20c3d276ce028ed5089ab1ce3dae902ea1d01c0873fd8c95f4918&c_id=6180483

    http://neweconomicperspectives.org/2013/09/stephanie-kelton-interviews-l-randall-wray-monetary-policy-economics-retirement-security.html

    1. fresno dan

      financial matters
      July 23, 2014 at 7:36 am
      thanks for the links – I’ll have to read them later as I am off to the Sacramento fair.

  4. beene

    John, the value of economist serve the same purpose as studies and congressional hearings; cover for the ignorant politicians we elect.

  5. dude

    Thank you. Good points. My question is, if bonds are paying near zero then why would people still seek bonds, rather than hold money? Bonds are near zero and money is near zero 0.10% (its not really a negative yield, is it?). “Today people are desperate to get their hands on bonds because holding money is eroding their portfolios due to the substantial negative yield being incurred.”

    If both are near zero interest rate wouldn’t the prudent choice be to seek return in the market, some well rounded index funds?

    1. Ben Johannson

      Low yield bonds can be said to have a negative interest rate if the rate of inflation exceeds the yield. So if you buy a security paying a 1% yield but inflation is 2% then your purchasing power will have actually decreased when the bond is redeemed.

      If both are near zero interest rate wouldn’t the prudent choice be to seek return in the market, some well rounded index funds?

      Depends on the type of investor. A pension fund is supposed to save significantly in high-quality bonds; an individual with lots of cash will put some of it in the safest financial asset she can find, which means treasurys. There’s a lot of cash out there looking for a safe harbor with high enough yield to avoid erosion by inflation. Stocks are viewed as too risky, particularly if you’re convinced the market as a wholw is overvalued.

  6. ddf

    What neither Keynes nor Minsky could write because they lived in times where the financial sector was not as large and regulated as it is now is the shortage of safe assets. Modern financial sectors required enough safe assets for hedging (e.g. pension funds that match the maturities of assets and liabilities), collateral (e.g. in the tripartite repo market that we know shockingly little about) or regulatory purposes (post-crisis regulations have increased regulatory demand for safe assets). What the Fed/BoE/BoJ have done is buy so many long maturity bonds that there is not enough left to satisfy the finical sector demand for safe assets. As a result long term yields levels and responsiveness to news are lower than they would otherwise be: compare e.g. the US 2 yr and 10 yr yields since last summer tamper tantrum. So the monetary authorities have not lost control over interest rates. Rather they have created an enormous distortion that is one of the channels generating extraordinarily lose financial conditions (one other channel is the risk taking channel that has gone berserk after nearly 5 years of 0 rates)

  7. Jim Haygood

    ‘I came across a very amusing piece from Krugman in 2010.’

    And I came across a 45 rpm record from 1962 at a garage sale. But it’s probably not worth writing about.

  8. Brian Romanchuk

    Hello Phil,

    In this case, I have to largely side with Krugman, at least based on the quote your provided (I did not read his full article).

    In dropping the mathematics, you ignored the significance of the textual qualifier “so low a rate of interest” in the Keynes quote. What he describes is exactly what has been happening in the U.S. Treasury market since 2010 (or whatever start date you want to pick). If you talk to investors, they will tell you that they do not want to own Treasurys at these low levels. But somehow, yields are still “low”. This is either because investors are forced to hold them (by convention or regulation), or not all investors think alike.

    Rather than trawl through Keynes’ writings, I looked at Minsky’s “John Meynard Keynes”. His description of the liquidity trap (pp. 36-37), as viewed by the “Keynesian” consensus of the day, matches what Krugman wrote. It is based on the shape of the LM diagram. In the diagram, the rate of interest flatlines at some “low” level. (Looking at the diagram – which implicitly uses mathematics – the idea appears a lot clearer than a textual analysis.) Minsky notes the problem that the question of which interest rate is in Hicks’ IS-LM was a muddle, but it was a muddle that one could work around by making some assumptions about bond market behaviour.

    One can debate whether the post-war “Keynesians” really followed Keynes’ thought. But by way of convention, it seems reasonable to call them Keynesian; they have been labelled in that fashion for decades. But in the case of the liquidity trap, it is unclear to me whether there is a divergence – increases in the money supply are ineffective in lowering (government) bond yields, which is what Keynes appears to be saying.

    If we turn to the so-called “New Keynesian” models, yes the models revolve around the zero lower bound, not a “liquidity trap”. Those models do not attempt to model the bond term premium, which causes them some difficulty. But if that term premium were modelled, you would end up bond yields hitting a lower bound above zero, which is exactly the “liquidity trap” behaviour I discussed above. Therefore, in practice a “zero lower bound” and a “liquidity trap” are equivalent conditions.

    As for the interest rates faced by private borrowers, pretty well any detailed analysis of the financial sector tells us that there is a spread between government rates and private rates, and that spread is not under the direct control of monetary policy. That spread is ignored in a lot of analysis, but my feeling is that their view was this is a simplification that needs to be taken into account, and can be worked around in practice.

    Since the Fed (and other developed central banks) does not have the legal mandate to impose negative interest rates, the possibility of their theoretical existence does not increase those central banks’ freedom of action.

    1. judabomber

      Krugman is wrong, IMHO.

      From Minsky’s Stabilizing an Unstable Economy, p 148:

      “Unemployment would be unresponsive to changes in the supply of money within the Hicks formalization if the interest rate is independent of the money supply. This is the famous liquidity trap – which holds that an increase in the quantity of money for certain ranges of income does not lower the interest rate.

      The liquidity trap renders monetary policy ineffective. Such a trap is possible in the aftermath of a financial crisis and will be characterized by low interest rates on default-free securities and substantial interest premiums on riskier securities.”

      So what are credit spreads doing? Of course one could argue the asset-swap of QE has something to do with this as well:

      http://research.stlouisfed.org/fred2/graph/?g=GdQ

      1. Philip Pilkington

        Thank you judabomber. Yes, Minsky is the other source on this. Note carefully the second half of that last sentence:

        “Such a trap is possible in the aftermath of a financial crisis and will be characterized by low interest rates on default-free securities and substantial interest premiums on riskier securities.”

        We DO NOT see “substantial interest premiums on riskier securities.” Janet Yellen is saying that we have TOO LOW interest premiums on high-risk (junk) bonds!

        Krugman is talking crazy talk!

        1. fresno dan

          Philip Pilkington
          July 23, 2014 at 2:44 pm

          I am really trying to understand this stuff – NC is a great resource to get some learned background on this.
          First, I don’t know exactly what the “BofA Merrill Lynch US Corporate Master Option-Adjusted Spread©” is, but I surmised it is the difference in interest rates between government bonds and corporate bonds, and when I looked at the chart it struck me that if there is only a 1% difference, that is a pretty low interest rate, so theoretically they are not risky (of course, judging by the whole MBS fiasco, wouldn’t a rational person ponder if bond buyers are the stupidest humans to have ever existed???) . So the question is, these are not very risky bonds? Is the economic situation such that we don’t have to worry about most companies going bankrupt (I mean, this might be entirely logical if they are banks bonds, as everybody knows banks are TBTF – maybe there is a whole list of other companies TBTF). I am pretty much of the impression that the US government would pay the bank bonds of bank investors before it would pay its own…but I’m just a cynic.

          1. Brian Romanchuk

            The “Corporate Master Index” is the investment grade corporate bond index (AAA-BBB).

            The “option adjusted spread” (OAS) is the “average” spread, when the caluclation makes adjustments for embedded options in the bonds. (Corporate bonds can often be called, which affects their spreads.)

            A 1% spread (100 basis points) is at the low end of its range, but realised credit losses for investment grade corporates over time is typically less than that (working from memory). An optimist could argue that this is just the risk premium being relatively low, but the bonds still take into account default risk. (I have no opinion on whethe that is true.)

      2. Brian Romanchuk

        My feeling is that Minsky is not being entirely consistent in his writings.

        But there are two different thimgs happeming:

        1) credit spreads were wide during and just after the crisis, but that is due to default risk. One can argue that those spreads were stabilised by monetary policy.

        2) government bond yields stop falling due to term premia. For example, Japanese 10-year yields have been well aove zero, despite the fact that few people forecast rate hikes. This is because people fear capital losses, as rates can only go up.

        The second mechanism is what appears to be consistent with Keynes’ phrase. Referring to corporate bond yields during the crisis as “too low” looks questionable.

        1. Philip Pilkington

          1) Yes they were. TARP and QE allowed us exit from the liquidity trap. Thank you Bernanke!

          Corp bond yields were “too low” prior to the crisis. As the crisis set in money ran from this “too low” level in cash substitutes. Tada! Liquidity trap.

    2. Philip Pilkington

      Brian,

      When he says “so low a rate of interest” he is referring to the rate at which the central bank is trying to hit. For example, in 2006-07 the Fed was happy with the Baa corporate bond spread hovering around 2%. But then in 2008-09 this spiked up to 6%. See:

      https://fbcdn-sphotos-c-a.akamaihd.net/hphotos-ak-xpf1/t1.0-9/1017551_10204602745248106_3273182458079403450_n.jpg

      The 2% there is the “too low” that Keynes is referring to. While the 6% indicates where the Fed lost control over rates as lots of Baa corporate bondholders ran into cash.

      This brings me to my second point. You seem to equate “cash” with money. But this is not what I mean and it is not what the financial community mean. You can see this in the following definition:

      “Many people think of cash as physical currency—actual bills and coins in circulation. For practical purposes, however, the term “cash” also includes traditional bank deposits, such as checking and savings accounts, where you generally have access to your funds on demand and without risk of losing any principal (up to FDIC limits).

      In an investment context, however, the definition of cash expands to other types of cash investments, including short-term, relatively safe investment vehicles such as money market funds, US Treasury bills (T-bills), corporate commercial paper and other short-term securities.”

      http://www.schwab.com/public/schwab/nn/articles/What-About-Cash

      Krugman et al don’t understand this but Keynes and Minsky were financial economists and they do. Thus, it is the spread between T-Bills and other assets that is the interest rate that the Fed try to control. It is when they lose control over this that we have a liquidity trap.

      Krugman is trying to sell a crude ISLM view of the world where “interest rates” mean interest rates on cash substitutes. It’s awfully crude.

        1. Brian Romanchuk

          With regards to your point about cash, I assume you are referring to my writings elsewhere (I did not see myself writing “cash” in this comment.)

          I like using “cash” when talking about balance sheets, to avoid the ideological overyones associated with “money”. It is the standard accounting concept of “cash and cash equivalents”.

          I may also use “cash” in the usual fashion of fixed income analysts, which are securities under one year in maturity, possibly including (high grade) corporates paper. I hope which usage I am using is clear in the context.

  9. Rodger Malcolm Mitchell

    The real problem is not about the definition of a “liquidity trap,” or whether that “liquidity trap” really is an economic trap of any kind. (It isn’t, simply because there are no good economic reasons for lowering interest rates to the point of a “liquidity trap.”)

    Rather, the real problem is whether we believe that one of the Fed’s assignments is to stimulate the economy. Sorry, it isn’t. Stimulating the economy is solely the job of Congress and the President.

    The Fed has two assignments: It is the nation’s clearing house for banking transactions, and it is the nation’s last line of defense against deflation and excessive inflation. Period.

    The Fed has one tool, interest rates, and that tool is effective for its two assignments, but useless for stimulating the economy. (Contrary to popular belief, low interest rates do not stimulate the economy.)

    So asking the Fed to prevent deflation and excessive inflation, while stimulating the economy, all with that one little tool, is silly — almost as silly as claiming that QE has some economic benefit.

    I suppose that so long as Congress and the President can shift the blame to the Fed for our poor economic performance, we’ll continue to be told silly stuff. But we don’t have to believe it.

    1. Jim Haygood

      If you are speaking about what ‘should be’ the Fed’s mission, many would agree with you. But in fact,

      In 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:

      “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

      This is often called the “dual mandate.”

      http://www.chicagofed.org/webpages/publications/speeches/our_dual_mandate.cfm

      As Bloomberg affirms in an article today titled ‘Jobs Hold Sway Over Yellen and Carney,’ when unemployment is high, the other mandate of monetary stability goes out the window:

      http://www.bloomberg.com/news/2014-07-23/jobs-hold-sway-over-yellen-carney-as-central-banks-set-to-split.html

      1. Rodger Malcolm Mitchell

        Perfect example of Congress shifting its responsibility. The Fed has not tools to accomplish the “dual mandate.”

        I’m surprised Congress didn’t include: “Walk on Mars, reduce air pollution and prevent global warming” in its mandate, since the Fed has the same tool for those goals.

    2. Carla

      It’s pretty obvious to anyone living in this country at this time that low interest rates do not stimulate the economy. But with a combination of low interest rates and QE, the Fed has made the banksters very rich indeed. It appears to many ordinary people that THAT is the Fed’s real job. With slavish support from Congress and the Administration of course.

      1. Rodger Malcolm Mitchell

        Correct. But what can you expect when the Supreme Court says money = speech, so Congress is bribed by unlimited “speech” contributions, to be followed by jobs paying lots of “speech” when the pols leave office?

        1. Carla

          I trust you join hundreds of thousands of Americans, then, in our support for http://www.WeThePeopleAmendment.org declaring that only human beings, not corporate entities, are not entitled to constitutional rights, and money is not speech.

          Since the Fed is a private corporation owned and operated by its member banks, and the Congress, Administration and Judiciary branches have been purchased by same, I’m sure it makes sense to some that clear distinctions be drawn to delineate their various responsibilities, but it’s pretty much a wash down here on the ground.

  10. tiger

    Yves, this could have been much simpler. Create an Open Thread about Paul Krugman and the content will come :)

  11. Edward Lambert

    Agreed… We are not in a liquidity trap.
    Nominal rates are at the ZLB because it is thought that the output gap is still large. Well, it is not as large as they think due to weak effective demand.
    I do not blame Krugman for not understanding effective demand though. Yet he should be figuring it out.

    1. diptherio

      You don’t blame Kruggy for not understanding effective demand? I was expected to understand it (and understand that it was the only type of demand that mattered) in Micro 111. Not getting that wanting something and being able to afford something are two very different things–and the first one don’t count if the second one don’t apply–is a pretty major failing for a supposed economist.

  12. n

    In criticizing a section of academics for getting it wrong it might help the readers to provide a concrete prediction. What’s going to happen that’s going to illustrate this error? Or will anything happen? Ever? (Anyone can explain what’s already happened, as badly as they want. There’s not much verification in that.)

  13. plantman

    Excellent post. And, very helpful.

    But one thing I’d like your opinion on…Krugman seems to use his views on “liquidity trap” to support existing monetary policy, whereas, Keynes likely would not have supported QE. Chapter 12, Keynes says something to the effect that he does not believe that monetary policy is effective when demand is weak. He supports (from memory) state directed fiscal investment.

    Now Krugman has called for more fiscal spending, but at the same time he has said that , in lieu of fiscal spending, he supports the Fed’s QE policy as if purchasing assets in effect is the same as negative rates.

    In other words, Krugman is actually a stealth monetarist …which may be why he has been able to keep his post at the NYT. (where you don’t get a platform unless you support the existing policy.)

    Sorry for rambling.

    1. MRW

      Not rambling at all, plantman. Astute comment.

      Chapter 12, Keynes says something to the effect that he does not believe that monetary policy is effective when demand is weak. He supports (from memory) state directed fiscal investment.

      Exactly. Congress doing its job.

      Now Krugman has called for more fiscal spending, but at the same time he has said that , in lieu of fiscal spending, he supports the Fed’s QE policy as if purchasing assets in effect is the same as negative rates.

      When all QE has done is remove $100 billion of interest income from the economy every year, and returned it to the Treasury.

  14. Larry Headlund

    First Keynes describes a liquidity trap emphasis added

    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.

    Then Krugman describes the same

    A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because ,nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.

    and finally

    It is a situation in which the rate of interest on bonds do not respond to an increase in base money. Let us be clear: in a liquidity trap people do not want to hold bonds. In a liquidity trap cautious investors spit bonds back onto the market, their prices fall and their yields rise.

    For Keynes and Krugman a liquidity trap is a time when cash is prefered to bonds because the return is so low. In Pilkington’s case cash is prefered despite bonds increased return. If you look at US Treasury Bill Rates over the past five years you don’t see any pattern of increasing yields.

      1. fresno dan

        Philip Pilkington
        July 23, 2014 at 2:35 pm
        Brian,

        OK, perhaps my dim little brain is catching your point.
        You (Pilkington) say:
        “When he (HE REFERS to KEYNES?) says “so low a rate of interest” he is referring to the rate at which the central bank is trying to hit. For example, in 2006-07 the Fed was happy with the Baa corporate bond spread hovering around 2%. But then in 2008-09 this spiked up to 6%. See:

        https://fbcdn-sphotos-c-a.akamaihd.net/hphotos-ak-xpf1/t1.0-9/1017551_10204602745248106_3273182458079403450_n.jpg

        The 2% there is the “too low” that Keynes is referring to. While the 6% indicates where the Fed lost control over rates as lots of Baa corporate bondholders ran into cash.

        ((I am not understanding why 2% is too low? risk was priced too low?? It doesn’t seem that much different now – is it too low now? And it also doesn’t seem to have much affect upon employment – is that fair? Should it be expected to affect employment???))

        This brings me to my second point. You seem to equate “cash” with money. But this is not what I mean and it is not what the financial community mean. You can see this in the following definition…”

        ((OK, so here you (Pilkington) seem to be saying 2% is too low an interest rate ?spread?))

        When he (HE REFERS to KEYNES?) says “so low a rate of interest” he is referring to the rate at which the central bank is trying to hit. For example, in 2006-07 the Fed was happy with the Baa corporate bond spread hovering around 2%”

        ((So I am looking at a graph of blue, purple and green lines….and all hell breaks loose in 2007/8 and it seems in about a year it gets back to where is was more or less and has been stable since than – now going on a good 5 years.))

        Now, for the strum and drang about the FED, did they actually control the interest rates of Baa for most of the last 10 years?
        And, did they control that Baa rate where they should have?
        Is there some difference in interest rate between US bonds and the Baa that is ideal?
        If so, how is that determined?

        Also, you (Pilkington) say:
        “Krugman et al don’t understand this but Keynes and Minsky were financial economists and they do. Thus, it is the spread between T-Bills and other assets that is the interest rate that the Fed try to control. It is when they lose control over this that we have a liquidity trap.”

        ((Now, when you say that the FED is really trying to control the interest rate not of US bonds, but of other corporate (interest bearing and/or paying assets? (are you saying that??? I am not trying to put words in your mouth – I am just trying to understand the intricacies of FED interest rate setting….what interest rates of what entities).
        Is this something most economists would agree on – JUST from the standpoint of terminology?
        How about from the standpoint of understanding what the FED is basically trying to do – – I don’t care what they think, but I do want to know if that is what most of them think?
        Because it is unclear to my reading of the popular financial press that the FED action in controlling interest rates is reported that way, i.e., the FED in not trying to control the US bond interest rate, but the spread between the US bond and corporate bonds (its always possible that was clear to everyone and I’m just too obtuse to know what is obvious)).

        1. Philip Pilkington

          1) 2% was the pre-crisis rate. When the crisis hit the markets said “nah, things are risky we want more yield”. So, they rushed into cash and the interest rate went up to 6%. When things died down the Fed brought rates back down — albeit not down to pre-crisis levels. I think they probably could though if they really tried.

          2) Yes, they basically controlled the yields on these assets in that the yields would gravitate toward the Fed rate. So, when the Fed rate was lowered they would go lower. But then in 08-09 the Fed lowered to zero and the other yields spiked. Liquidity trap!

          3) Yes, economists all think that the Fed tries to control interest rates across the board. Or, at least, they should. But they rarely discuss it anymore. Why? Because they’re more interested in playing games with models than discussing real world issues. Krugman is more interested in fobbing the ISLM off on people than thinking through how financial markets work.

          4) I agree that reporting does not reflect this either. I would argue that is due to people like Krugman and poor economic training. Hence the post! ;-)

      2. Larry Headlund

        So the definition of cash includes Treasuries but excludes short term commercial paper and short term private bonds, per your followup. I note than in the Keynes’ chapter you linked to when bonds are mentioned it is in contrast to cash while most of the narrative is about rates of interest; not limited to bonds. That is going to make quoting tricky.

        You say that there was a liquidity trap in 2009-2010 and there is not one now. Does the Keynes’ quote apply to the situation in 2009-2010? (Keynes never uses the phrase ‘liquidity trap’ in General Theory’.)

        At the end of section III there are four examples of the limits of the monetary authority’s ability to establish rates of interest. The quote is the second example. Note that the US in the mid-1930’s is often cited as an example of a liquidity trap, Minsky, which you quote in an earlier article

        The liquidity trap presumably dominates in the immediate aftermath of a great depression or financial crisis.

        But Keynes (1936) says in this very paragraph that this situation has never occurred. In the third example Keynes speaks of the banking crisis in the US in 1932, where money would not be parted with on any reasonable terms, but this is distinct from the second example.

        1. Philip Pilkington

          Well after 1929 the Fed famously let the banks fail. So we never did see if central bank intervention would have driven down interest rates and calmed markets. My guess is that it wouldn’t have and there would have been a liquidity trap.

  15. kevinearick

    Specialization: Executive Summary 4 Idiots

    Idiot: a foolish or stupid person

    The only exit from the past, is the future, and the majority chooses to tax the future to subsidize the past, to avoid change. The easiest way to exit is not to enter, the peer pressure casino, decision by committee.

    If you care to understand the human clock, an extension of gravity, is assembled, spend time in each event horizon, listening to your body, which will engage your intellect, until it engages your spirit, when you exit. With experience, you can traverse the clock at will, simply by changing your appearance.

    But, the only way you will learn anything about life is to have children, provide for them, and refuse all offers of peer pressure association, at which point you will be targeted by the empire, which will apply increasing force over time, attempting to prove that you can be replaced, like all the others, which, of course, it can’t.

    It’s a distillation, and getting emotional isn’t going to change a thing. Emotion is the clutch, when logic fails, which means you need another gear. The more skills you have, the more irrelevant the gravity of empire becomes.

    Without imagination, the empire can only travel downhill, and it will discard skills as it does so, because the planet will offer it paths of decreasing resistance, in greater duration mismatches. All you have to do is turn uphill, easier said than done, unless you have acquired the experience, before you need it.

    Assuming that this planet is as stupid as human peer pressure, that an irrational automaton herd can outlast all intelligent investors, is a bad assumption. Laws follow behavior, which follows relationships, except in a pendulum, which is the timer.

    The dumbest argument yet is that the 1% can control the 99%, and that the answer to group occupation is group occupation. The 1% controls only the majority, and by consent, with an upper middle class rigged lottery, a licensing monopoly employing debt as income, to inflate assets with debt, Warren Buffet’s moats, employing the rest of the middle class as a disposable income shock absorber.

    For the completely clueless, we are talking about propulsion systems, employing human behavior as an example, so the kids building out the system have no need of explicit communication. Yes, it is my kernel consuming the consumers, and I am telling you how it works.

    The enemy of my enemy is my friend, last-to-lose marriage, in a civil contract built to be broken, doesn’t work, but keep trying, while the majority replaces itself, with a computer designed to mirror itself, on an assumption of stupidity. Build a better kernel if you can, but be quick about it, before a Boeing falls on your head.

    “For every missile Krupp sent over, GM replied with four.” Yes, you can row a boat across the Pacific, happens all the time, and far quicker than the empire can change course. If you are going to attack, you might want to have a weapon. Occupy yourself, and you have no need of weapons.

    It’s not just the Chinese buying MAD mortgages in San Francisco.

    1. kevinearick

      “There are few alternatives to buying poor value for money”

      “The bigger prize is winning the economic marathon by achieving a durable expansion.”

      Where do you suppose the oligarchs, the Russians in particular, put all their money? Why did the Germans bomb London, and why did America wait to bomb Berlin?

      You might not want to place all your eggs in San Francisco, but do what you want. Labor doesn’t care who controls the laws or the money, because they are all the same, seeking something for nothing, in one duration mismatch or another.

  16. Linus Huber

    It certainly is important to agree on certain terms like e.g. liquidity trap. The question is probably the context applied to the term in order to arrive at a reasonable definition.

    From my probably very limited point of view, it all boils down to the question what behavior will produce the best result for the individual and how far those actions are influenced (enforced) by the concerned decision makers. If the decision makers threaten the cash-holder with the devaluation of the currency, he will try to avoid holding the currency which in turn reduces the threat of a “liquidity trap”. In looking at the forest instead of the individual trees I recognize that this manipulative endeavor has been entertained and steadily increased by central banks since decades now, so that the “moneyness” of the currency has been decreased and the “moneyness” of credit correspondingly increased. The present actions by central banks is an extension of this model by introducing ever more measures to avoid volatility in the value of debt. That this development is very much a Ponzi scheme is probably obvious for most of us.

    To put it into a wider perspective, how much more does the population likes to be manipulated, regulated, controlled and monitored by the increasingly corrupt thinking of those decision makers and when will this all boil over.

  17. TinMan

    You lost me here: ” <blockquote cite="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.

    So, a liquidity trap is a situation when the central bank pumps in money and the rate of interest doesn’t respond. People say: “Meh, I don’t like the look of those bonds, I’ll just hold this cash”, and so bond prices remain high.“> .

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