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It's one thing to say that there is no historical evidence of a liquidity trap, but this guys understanding of economics is too poor to critisize Keynes.
This is not what Keynes proposed. He proposed fiscal policy. He said that monetary policy would have no effect.
Austrian School. So this person is against any stimulus at all, not just stimulus under the situation he is discussing.
Keynes did not contradict himself. He never considered the determinants of the interest rate to be hard fast. This is obvious since he suggested that the demand for money is inversely related to the rate of interest during a liquidity trap. The difference is that Keynes said the determinents of the interest are relative to the situation.
The long-term interest rate is determined by savings true, but long term savings (investment) is determined by the short-term success of the economy. Anyway, Keynes was not concerned with the long-term. This guy is trying to say that Keynes meant that the long-term interest rate was not determined by savings and that is just too wrong.
Keynes didn't say that causation runs both ways. He meant that deflation would cause a liquidity trap at one point in time, and after that the liquidity trap would cause further deflation. These are two different effects. Each effect has a different cause. No causation running two ways.
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This guy is a sad excuss for an economist.
Enough nonsense about the liquidity trap
By CHRISTOPHER LINGLE
Special to The Japan Times
Tokyo's cutting interest rates was once the response to borrowing costs being too high or credit too tight. Despite no indications that the financial system is deprived of liquidity, the Bank of Japan and the U.S. Federal Reserve Board continue to hold or push down interest rates.
Unfortunately, both the BOJ and the Fed are acting upon a mistaken belief that money must be pumped into the system before a "liquidity trap" develops.
The notion of a liquidity trap has a long and dubious history. It was contrived by economist John Maynard Keynes to describe a situation in which low interest rates induce bondholders to express a "liquidity preference" to the extent that it interferes with monetary pumping aimed at stimulating the economy.
The logic is that investors will worry that an eventual rise in interest rates will cause them to suffer capital losses as bond prices decline. This encourages an increase in the demand for cash balances (liquidity preference) that is so great that the interest rate cannot fall low enough to stimulate investment.
One implication is that rates will not react to increases in the money supply and that economic growth becomes immune to monetary pumping. At very low interest rates, the demand for cash increases to the point that new injections of money into the system are hoarded instead of spent. This means that the portion of wealth held in the form of cash balances becomes so intense that the rate of interest can never go low enough to stimulate investment spending.
Given the conditions of Japan's current economic malaise, a liquidity trap may seem plausible. But neither is it the cause of Japan's economic problems nor is it likely to afflict the United States. In Japan' s case, irresponsible monetary policies made Japan's economy and its financial sector deeply dysfunctional.
When a liquidity trap is supposedly sighted, the proposed cure is for central banks to print lots of new money to buy up bad loans in the banking system and the overvalued assets of corporations. As paper money floods the economy, negative interest rates occur and prices rise rapidly. The whole point is to boost aggregate demand. Negative interest rates tend to discourage saving by lowering borrowing costs. Inflation, on the other hand, encourages people to buy more today to avoid higher prices tomorrow.
By CHRISTOPHER LINGLE
Special to The Japan Times
Tokyo's cutting interest rates was once the response to borrowing costs being too high or credit too tight. Despite no indications that the financial system is deprived of liquidity, the Bank of Japan and the U.S. Federal Reserve Board continue to hold or push down interest rates.
Unfortunately, both the BOJ and the Fed are acting upon a mistaken belief that money must be pumped into the system before a "liquidity trap" develops.
The notion of a liquidity trap has a long and dubious history. It was contrived by economist John Maynard Keynes to describe a situation in which low interest rates induce bondholders to express a "liquidity preference" to the extent that it interferes with monetary pumping aimed at stimulating the economy.
The logic is that investors will worry that an eventual rise in interest rates will cause them to suffer capital losses as bond prices decline. This encourages an increase in the demand for cash balances (liquidity preference) that is so great that the interest rate cannot fall low enough to stimulate investment.
One implication is that rates will not react to increases in the money supply and that economic growth becomes immune to monetary pumping. At very low interest rates, the demand for cash increases to the point that new injections of money into the system are hoarded instead of spent. This means that the portion of wealth held in the form of cash balances becomes so intense that the rate of interest can never go low enough to stimulate investment spending.
Given the conditions of Japan's current economic malaise, a liquidity trap may seem plausible. But neither is it the cause of Japan's economic problems nor is it likely to afflict the United States. In Japan' s case, irresponsible monetary policies made Japan's economy and its financial sector deeply dysfunctional.
When a liquidity trap is supposedly sighted, the proposed cure is for central banks to print lots of new money to buy up bad loans in the banking system and the overvalued assets of corporations. As paper money floods the economy, negative interest rates occur and prices rise rapidly. The whole point is to boost aggregate demand. Negative interest rates tend to discourage saving by lowering borrowing costs. Inflation, on the other hand, encourages people to buy more today to avoid higher prices tomorrow.
Yet attempting to stimulate demand artificially only worsens the overall condition of the economy. Price inflation can sustain output only if it restores profitability to the pool of unsound investments undertaken in response to artificially low interest rates. Rising profitability will happen only if costs fall relative to the monetary value of the output. But this only allows ill-advised investments to continue while encouraging more bad ones, thus setting a course for a more severe downturn in the future.
The notion of a liquidity trap reflects a puzzling and contradictory reversal of the Keynesian notion of the determinants of the interest rate. And not only is his monetary explanation misleading, it also lacks theoretical and historical support. In most of his work, Keynes portrays interest rates as being determined by liquidity preference relative to the supply of money. But in specifying a liquidity trap, he suggests that the demand for holding money is inversely related to the rate of interest.
By confusing the idea of cash holdings with savings, Keynes thought that increases in savings would reduce investment by reducing consumption spending -- he portrayed investment as depending upon more spending rather than upon increased savings. But it is only savings that can naturally and permanently bring down long-term interest rates.
It turns out that the conceptualization of the liquidity trap reverses the Keynesian explanation of the determinants of the interest rate. In Keynes' formulation, interest rates are determined by liquidity preference and the supply of money. However, when speaking of the liquidity trap he specifies that the demand to hold money responds inversely to changes in the rate of interest.
Few theorists would be bold enough to express causation as running both ways. But Keynes assumes that the demand for cash determines the rate of interest and that the rate of interest is determined by the demand for cash.
Few theorists would be bold enough to express causation as running both ways. But Keynes assumes that the demand for cash determines the rate of interest and that the rate of interest is determined by the demand for cash.
Paul Krugman is an articulate modern proponent of the liquidity trap, but he is as confusing as Keynes. Krugman has suggested that when an economy is caught in a liquidity trap, it will slide into deflation. But then he states that deflation can push an economy into a liquidity trap. Like Keynes, he apparently likes to have it both ways.
Urging central banks to create inflationary expectations by flooding an economy with money is fundamentally irresponsible. By causing them to misread capital costs relative to future demand, cheap credit causes entrepreneurs to waste capital and savings.
While central banks can certainly flood an economy with money, this will not increase the productive capacity of the economy, but it can cause harmful distortions in the structure of production. By forcing interest below market rates, excessive credit formation occurs so that firms are induced to invest in unprofitable or unsustainable projects. Economic booms based on "cheap money" result in a cluster of errors and misguided investments that cannot be completed because there will be insufficient capital in the form of producer goods in the future.
All this eventually leads to a profit squeeze when these firms find that returns don't cover rising costs. Eventually unemployment rises and idle capital appears, while consumers try to restore their desired savings-consumption ratio.
Despite the logical inconsistencies and complete lack of historical evidence of their instances, the notion of the liquidity trap is likely to survive. Politicians like this fiction since it provides a logical argument to disguise their penchant for irresponsible increases in spending of taxpayers' money. But neither Japan nor the United States can be considered in the throes of this mythological beast.
Christopher Lingle is a visiting research scholar at Hitotsubashi University and Professor of Economics at Universidad Francisco Marroquin in Guatemala. His e-mail address is: CLingle@ufm.edu.gt
The Japan Times: July 24, 2003
Urging central banks to create inflationary expectations by flooding an economy with money is fundamentally irresponsible. By causing them to misread capital costs relative to future demand, cheap credit causes entrepreneurs to waste capital and savings.
While central banks can certainly flood an economy with money, this will not increase the productive capacity of the economy, but it can cause harmful distortions in the structure of production. By forcing interest below market rates, excessive credit formation occurs so that firms are induced to invest in unprofitable or unsustainable projects. Economic booms based on "cheap money" result in a cluster of errors and misguided investments that cannot be completed because there will be insufficient capital in the form of producer goods in the future.
All this eventually leads to a profit squeeze when these firms find that returns don't cover rising costs. Eventually unemployment rises and idle capital appears, while consumers try to restore their desired savings-consumption ratio.
Despite the logical inconsistencies and complete lack of historical evidence of their instances, the notion of the liquidity trap is likely to survive. Politicians like this fiction since it provides a logical argument to disguise their penchant for irresponsible increases in spending of taxpayers' money. But neither Japan nor the United States can be considered in the throes of this mythological beast.
Christopher Lingle is a visiting research scholar at Hitotsubashi University and Professor of Economics at Universidad Francisco Marroquin in Guatemala. His e-mail address is: CLingle@ufm.edu.gt
The Japan Times: July 24, 2003
This guy is a sad excuss for an economist.
How were Keynes' predictions about the treaty's effects wrong?
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