Philip Pilkington: Financial Times Contributors Understand ‘Liquidity Trap’ Better Than Neo-Keynesians Like Krugman

By Philip Pilkington, a London-based economist and member of the Political Economy Research Group at Kingston University. Originally published at his website, Fixing the Economists

I have long complained that the likes of Paul Krugman have grossly misinterpreted the meaning of the term ‘liquidity trap’. These economists seem to think that we are currently in a liquidity trap despite the fact that yields on bonds are extremely low across the board.

I have also long insisted that this is not simply an issue of “what Keynes really said” (it rarely is with me, but there is little point in shouting at those without ears to hear). Rather this is an eminently practical issue: the Keynesian idea of a liquidity trap is an extremely useful one when examining financial markets. It allows us to discuss interest rate dynamics at a granular level — something mainstreamers (and even some Post-Keynesians) are unable to do in any consistent way.

People working in financial markets often have a far better intuitive sense of this than economists. Yesterday the head of macro credit research at RBS Alberto Gallo did us all a great favour by utilising the term ‘liquidity trap’ properly in a column in the Financial Times entitled ‘Unwary Yield Hunters at Risk of Liquidity Trap’. First of all he highlighted the very non-liquidity trap environment that we are currently in. He wrote:

During the past five years, credit markets have attracted less experienced investors who switched from low-yielding Treasury bonds and money market funds to investment-grade and high-yield debt.

That’s right: in the current environment interest rates on risky assets have fallen, not risen as they would in a liquidity trap. In the article he highlights that liquidity might flee the market if the Fed engages in tightening monetary policy. He correctly points out that this could lead to a liquidity trap as liquidity flees the market and yields on risky bonds get stuck or trapped at a higher level. He writes:

High-yield bonds have had a record run. With a cumulative return of more than 150 per cent since 2009, they have beaten stocks in three out of the past six years. But the market is now stumbling, and regulators have highlighted signs of frothiness… Yields are near record lows and liquidity in secondary markets is declining, making it harder to exit swiftly… Low liquidity can “trap” sellers, accelerating price falls. This makes credit markets vulnerable to an exit from loose policy. (My Emphasis)

You see? Gallo considers the ‘trap’ a situation in which the price of the bonds falls and thus the yields rise. Just to drive that home he finishes his excellent article thus:

Liquidity in secondary markets is evaporating, and policy makers are shifting their focus to credit markets… Yield hunters should consider selling or they could get caught by the credit liquidity trap.

I’m not even necessarily endorsing the views of Gallo on the state of the market — I’m not as confident as he seems to be that the Fed will reverse course on their monetary easing. But I am endorsing his intuitive and correct use of the term ‘liquidity trap’. Gallo understands that a liquidity trap is what occurs when money flees risky asset markets; the prices of these assets then declines and the yield rises. This is precisely what Keynes and Minsky meant by liquidity trap.

While Minsky and Keynes generally discussed the liquidity trap as a general phenomenon that occurred across markets when the demand for risky bonds dried up and everyone fled to money and money substitutes, Gallo is perfectly correct that we can apply this term to specific markets. I see no reason why we cannot talk about a liquidity trap in a specific market. To be wholly consistent the Fed would have to lose control over the rate of interest in this single market — and it is not altogether clear that this would be the case in Gallo’s scenario — but I think that Gallo, who intuitively senses that a liquidity trap occurs when money evacuates a market and yields spike, is at least on the right track.

Is Gallo the Talmudic Keynes scholar that some people insist I am, always using terms in the ‘correct’ manner due to some sense of duty or impulse for dogmatism? I doubt it. It is far more likely that he is an experienced and capable financial market analyst who has come to the conclusion that this is a useful term to describe a certain phenomenon. As I have argued in the past, however, the term as used by Krugman et al is not a useful term. Rather it is synonymous with ‘zero interest rates’ and seems to me to be only used to hide the fact that they are saying something banal under the cloak of a term familiar in neo-Keynesian economics.

Don’t expect the neo-Keynesians to understand this though. They are so clueless about financial markets it is amusing to the point of almost being embarrassing. I sent one of the well known neo-Keynesian bloggers the link to the last post on Twitter. His response? “Someone tell this guy that yields and interest rates are the same thing”. You can’t even make this stuff up. And this guy brags about teaching… financial economics. Excuse me while I rush for the escape hatch.

I am beginning to suspect that economists this lacking in financial diction probably can barely even read the financial press — and if they do try you can be sure that after the material has been swallowed without chewing, almost nothing is digested. Lord help us if they ever get in charge or gain influence by training policymakers… oh wait…

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  1. Jose

    I am beginning to suspect that economists this lacking in financial diction probably can barely even read the financial press

    There are exceptions, though.

    Perry Mehrling’s excellent “Money view” course on Money and Banking (available for free online) at Columbia starts every session with a reading of a top story of the FT – and how to interpret it.

    No doubt his students would appreciate Gallo’s column on the Liquidity trap.

  2. Ignim Brites

    Isn’t it the point of the Keynesian idea of a liquidity trap that real returns (real interest rates) on money increase even though the nominal rate is zero. The ZLB therefore intensifies the liquidity trap in PP’s sense in other markets because increasing liquidity preference increases the real return to money; I.e. prices of other assets fall.

    1. Ben Johannson

      In a gross sense Keynes’ liquidity trap occurs when everyone holds cash and rejects bonds. It doesn’t necessarily mean cash is yielding anything better, only that people believe cash is the smart bet. Investors might think interest rates will rise and so hold off purchases, or expect the bonds won’t be honored. ZLB lowers yield and increases price.

  3. cnchal

    Short form summary. we r scruud.

    Thank you for throwing down the gauntlet and challenging them.

    For the majority, where the money comes from in your paycheck is so far removed from the customer you serve, that it might as well be magic.

    For economists it is magic. How else can so many of them earn such astronomical amounts relative to most people, get it wrong time after time, and still be employed?

    1. digi_owl

      “For economists it is magic. How else can so many of them earn such astronomical amounts relative to most people, get it wrong time after time, and still be employed?”

      The term “useful idiots” comes to mind…

      1. cnchal

        Useful to whom?

        This post discusses the definition of a liquidity trap, and how Krugman and neo-Keynesians, either through lack of inteligence or a deliberate attempt to mislead get it wrong. Either way, if true, means that Krugman and his ilk are grossly overpaid for the disservice they render, and should be in the unemployment lines looking for gainful employment, where they can be exploited by someone that can put them to useful work.

        Who benefits from this? It is alarming that economic definitions like liquidity trap are argued over by economists.

        Conceptually, I think I understand Alberto Gallo’s explanation. When interest rates are expected to rise, no one wants to buy a bond until they have reached a discernable peak, because the instant that one buys a bond, it drops in value with the next uptick in interest rates. Guaranteed to lose. The people that bought bonds when interest rates are low are doubly screwed, because the value plummets, and there is no one waiting to buy, and releive the pain.

        1. digi_owl

          Economists in general push for “free market capitalism” in one form or other. The ones that benefit from that are the monied elites.

          Sure, there may be division within that group. But in general they want “free market” over anything else.

  4. Lrellok

    I think the failure is on both sides. Lemme try t explain.
    “His response? “Someone tell this guy that yields and interest rates are the same thing”. ”
    What would someone need to think in order to say this? That bond prices should be normally rigid, that a few bonds in a few places might change price, by that is very rare and to be frowned upon.
    This makes sense of you think in terms of optimal efficiency being something markets actually do. If the purpose of bonds is to price investment risk, and the mechanism for pricing the risk is the interest, then if risk is being priced effectively the yield and the interest should be the same number, since a change in the price of the bond would reflect a change in the price of the risk. The bond is worth less because it is more risky, then the risk was not correctly priced when the bond was issued.

    Economists since Marx’s critique have served the duel role of explainers and justifyers. On one hand they need to tell people how the market works, on the other hand they need to tell people that the market works (in the case above, not all the same thing). This is the origin or your disjunction, the economist is saying that if yields and interest are at significant variance, markets are not working, and since markets have to work, yields and interest cannot be at significant variance.

    1. Yves Smith Post author


      The issue is interest rate volatility…..and that there is no one “interest rate” but a term structure of interest rates.

  5. Linus Huber

    Well, let’s look at it from the view point of each proponent.

    Krugman and Co. looks at it from the point of view of those who think that the use of monetary policy (transferring the cost of credit risk onto the currency) is to be a positive without negative consequences down the road confirming the idea of what is to be considered a bad economist who simply is able to see the immediate result from their implemented action. They use the term liquidity trap to justify their interference with the risk premium demanded by the market.

    Gallo shows a glimpse of the consequences of these actions and explains a potential pitfall for those masters of manipulation in that not all markets may be addressed with macro-economic prudence which results in pockets of what one might call a liquidity trap in that risk premiums are suddenly returning to the concerned corner of the credit markets as central planning by monetary authorities starts to fail.

    The result may well be that the monetary authorities will enhance their capabilities and grow their bureaucracies (don’t they all love to grow on us) in order to deal with each individual potential problem. Once you have chosen to resolve increased risk premiums by means of currency devaluation it becomes harder and harder to change course.

  6. plantman

    Perhaps, Krugman’s intention is actually more sinister than you think??

    Consider this for a minute: The neo-Keynesians seem to think that if you’re in a liquidity trap (as they define it) you need to achieve negative rates to slow deflationary pressures and boost activity by creating incentives for borrowing. That, in turn, justifies QE which some think is an effort to lower rates below zero.

    The irony is that this is the exact opposite of what Keynes recommended, which was sustained state investment. (fiscal)
    Krugman is always touting Keynes so he appears like a liberal to his readers, but much of what he’s peddling strikes me as monetarism.

    Of course, I could be wrong(?)

  7. MaroonBulldog

    Doesn’t “liquidity trap” (as Keynes used it) basically signify a condition in which he stated interest rate to be offered on future obligations is expected to rise to such a degree that the discounted present value of of existing obligations with fixed interest rates is expected to depreciate more rapidly than the currency devalues? Or, in other words, a condition in which a zero yield on currency is a better risk adjusted return, on a present value basis, than the presently available yield on purchase on an existing obligation? And doesn’t Keynes discuss an equation with a real valued solution show that such a condition can come to exist in the real world? What’s so difficult to understand about any of that? And if someone uses the term “liquidity trap” to signify a different condition, then aren’t they just giving it a different meaning, or maybe just making it a buzz word?

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