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Can one be a liquidity trap denialist?
Paul Krugman thinks not:
No matter how much Japan increases the monetary base now, expectations of future money supplies won’t move if people believe that the Bank of Japan will move to stabilize the price level as soon as the economy recovers. And once you realize that central banks may not be able to move expectations about future money supplies, it becomes a real possibility that the economy will be in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy.
There is more so read the whole post. I'll put my comments under the fold...
Let's say the central bank targets the (eventual) rate of price inflation and not the price level itself. Then even a one-shot burst of helicopter-drop money induces more consumer spending rather than more money demand. It was Meyer Burstein who best explained Patinkin's "real balance effect" in terms of weakly dominant game-theoretic strategies. If you wait to spend your money, later prices will be higher, if only with some probability (thus it matters that the central bank commits to a preferred rate of forward-looking inflation, rather than restoring the previous price level; the latter would mean deflationary expectations and possibly take away the real balance effect). Nothing in the Patinkin/Burstein logic requires any particular degree of optimism about economic conditions. In fact very pessimistic consumers may be the most likely to scramble after goods now, again putting the real balance effect into play and pushing up prices. Nor is a strongly positive nominal interest rate required for the real balance effect. Don't be fooled by representative agent models which draw a single flat horizontal line for the return to holding money curve; this is about game theory.
The greater a hoard of cash you are holding, the more likely that the spending behavior of other consumers will inflict a negative pecuniary externality on each consumer and thus again the more likely a real balance effect, following a helicopter drop of money. Of course with interdependent strategies there are usually multiple equilibria. You can get a "liquidity trap equilibrium" by postulating an adjustment cost to portfolio decisions, combined with just the right kind of a trigger strategy equilibrium (everyone holds her new money cautiously, but poised to strike with quick new spending, if need be). In that sense I am not a pure liquidity trap denialist although I think such an equilibrium is unlikely.
Here are my previous posts on the liquidity trap.
Posted by Tyler Cowen on November 17, 2008 at 06:25 AM in Economics | Permalink
Comments
A central bank that targets the price level is daft. It cannot achieve what it is targetting, and the market will realise that. A central bank that is targetting the expected rate of inflation is really in business.
If the target is believed, and it should be because the central bank has instruments to achieve its aims, whatever quantity of money the helicopers drop will be expected to be mopped up before the cash raises the long run expected inflation rate. Therefore it makes sense for the finders of the money to use it for cutting debt/boosting assets.
As Tyler says, it is all about game theory; but a central bank that is targetting expectations is a dominant player.
Posted by: David Heigham at Nov 17, 2008 7:43:02 AM
The question "Can we print money?" is very important right now.
If we can meaningfully print money-- if money printed won't just get hoarded by people in banks and by banks and the Fed, and thus disappear as soon as it appears-- then we can ignore calls for spending on the grounds that monetary policy won't work.
Public spending is typically wasteful, since it involves real economic activity directed by government bureaucracies not in response to price signals. That makes it a somewhat perverse response to bad economic times (though some infrastructure spending might be all right, since it has a built-in exit strategy: once the road or port or bridge is built, the project has nowhere else to go and liquidates itself). Stabilizing or reflating the monetary unit is not so directly and inherently inefficient, so if it can be done, there's a reason to prefer it.
(Krugman has a reason to insist on a liquidity trap: he wants to use the crisis as a pretext for a new New Deal, so he has to pretend that government spending is the only macroeconomic fix. But it's not at all clear that that's even a theoretical possibility, let alone the actual case today.)
Posted by: Nathan Smith at Nov 17, 2008 8:52:34 AM
By the way, are we using the wrong price index?
In the 1990s and up until 2005 or so, asset prices were inflating, while consumer prices were steady. The Fed ignored asset price inflation, except inasmuch as it influenced consumer price inflation.
Now asset prices are deflating. Even though this is causing major problems for the economy, the Fed is not trying to reverse it by "printing money." Because its mandate is consumer prices?
But why should *consumer* price inflation be the kind we worry about? Now that we've seen how problematic asset price inflation can be (that is, of HOUSES especially, and to a lesser extent stocks), might it be reasonable to adjust the Fed's mission to stabilize some broader price index which includes house prices and maybe even stock prices?
If the Fed had been pursuing this policy since the mid-1990s, we would have tolerated a good deal of consumer price *deflation* since then. I suspect that wouldn't have done as much harm as the popping of the housing bubble is causing us now.
Posted by: Nathan Smith at Nov 17, 2008 8:57:07 AM
Public spending is typically wasteful, since it involves real economic activity directed by government bureaucracies not in response to price signals.
If you don't like public spending you could do it this way: Give every voter a federal debit card. And put the money in their accounts. Tell them if they don't spend it this month, the government will take it back.
Some people will try to cheat and find ways to save the money, but probably not many.
Some people will use the money to pay down their credit cards. That's good. The less they pay in interest each month the more they can spend.
It may be patriotic to take on debt during a recession so the recession won't get worse, but should we expect that of american families?
Posted by: J Thomas at Nov 17, 2008 10:34:01 AM
It would seem easy to stall or reduce the decline in house prices (at least in nominal terms) by using treasury bond borrowing to finance low interest mortgages. I think that the housing market would at least begin to stabilize if 5% or 4% mortgages were available..and it would help those in danger of losing their houses. Of course it would be a massive transfer of wealth the house borrowing community, but they are as deserving as bank stockholders.
One problem would be to stop yet another bubble.
Posted by: RobbL at Nov 17, 2008 10:34:02 AM
I'm willing to go just so far with people who understand that the efficient market theory is precisely wrong but roughly right because it underestimates psychology, but I'm not willing to go so far as to believe that psychology is the cause of inefficiencies that last decades.
Posted by: Andrew at Nov 17, 2008 12:36:49 PM
The right way to target the price level would be to target the expected price level several years out. Five years out has always seemed like a pretty good interval to me. To do this, you would:
1. Decide on a target path for the price level for, say, the next ten years.
2. Use TIPS data to derive the market's expectation of the CPI five years from now. If it's higher than the target path, raise the federal funds rate by 50 basis points a month until the expected CPI five years out is back on path.
You could, of course, modify the rule to target a corridor rather than a path, and move the funds rate less aggressively as you approached the target, but the idea is still the same.
There is a lot to be said for targetting the price level, rather than the inflation rate. With an inflation target, the variance of your prediction error for the price level N years out grows linearly with N, while with a price level target, the prediction error variance is bounded. Less uncertainty would lead to more long term investments and eventual higher productivity.
Posted by: jeff at Nov 17, 2008 12:46:51 PM
I suppose I should study Krugman's model more carefully, however, it seemed to me that it assumes that a higher price level would raise the price level, however, because the moeny supply would be decreased in the next period, the expected deflation would cause an increase in the demand for money. The result is that the increase in the money supply is offset by an increase in money demand, leaving the price level unchanged.
It shows how stabilizing speculation helps the central bank maintain its interest rate target.
Interesting, but not relevant to an inability to use monetary policy to maintain spending at the current growth path of prices.
The economy slows. Prices rise more slowly. They are below the target. The result is that inflation needs to pick up for a time and then slow back on the long run growth path.
We aren't looking at a situation where there central bank seeks to engineer a spike in inflation that it will reverse later.
of course, maybe I must didn't understand.
Anyway, helicopter drops are monetary policy and fiscal policy at the same time.
It seems to me that some of this discussion is balling up the "tax cuts vs. spending increases" in the context of fiscal policy.
Posted by: Bill Woolsey at Nov 17, 2008 4:02:05 PM
The way that open market operations are carried is by buying government bonds with dollars. When the i-rate is 0% bonds and money are the same thing so changing one for the other makes no difference on the economy. Now if you want to have an effect you need to increase use helicopter drops. Start giving money away like crazy, so much money that it cannot be stored under mattresses, so much money that a typical family has enough cash sitting around to go out and buy a car, a house, a 62'' flat screen tv, a 3 week family vacation at Disney, what the hell, so that they can buy all stocks and bonds in the US... Now tell me that that is an equilibrium, tell me that prices will not start to increase and tell me that there will not be too much money chasing to few goods. Liquidity trap my @$$!
Posted by: at Nov 17, 2008 4:06:13 PM
I didn't read the comments at PK's blog, so I don't know if anyone pointed out the elementary fallacy in his reasoning. He used the word "hoarding" instead of saving to describe what he thinks people will do with new money when interest rates are low.
I doubt he could have used the term saving with a stright face.
Earth to PK: when bank interest rates are low, people will either spend the new money, or use it to pay down debt. When bank rates are high, they will save more.
In M,E&S, Rothbard criticized the Keynesians for overlooking (like they ever knew) that when i rates fall, people consume more and save less.
When Krugman returns from collecting his Nobel loot ($1.4 big ones), I have an Ellsworth Toohey Award for him, which he actually has earned, unlike the Nobel.
And while we're on the subject of big ones, he's all hot and bothered by the distribution of income. Will he give away his new money to people with lower incomes?
Didn't think so. That's something a limo lib. would rather have other people do, preferably under the lash of a tax collector.
Posted by: Bill Stepp at Nov 17, 2008 7:09:21 PM
The liquidity trap may show the point that we don't yet understand how much monetary policy really does nor why. Maybe monetary policy has small and variable effects most of the time on the real economy, but since there is so much noise that monetary looks somewhat effective. In the extreme periods like now, we ask way too much of monetary policy, and so it appears ineffective. Hence, the liquidity trap. But we are always at it, anyway.
I am not sure myself of the right answer.
Or maybe monetary policy can't ever help, but getting it wrong can really hurt.
Posted by: notsure at Nov 17, 2008 9:20:41 PM
I contend that US is not in a liquidity trap but in the debt trap. I wonder if some economists are considering the difference between a stimulus and a drug. U.S. economy is debt addicted, and what are we suggesting here? More drug debt to the addicted economy. US macroeconomic ratios are already well over the alarm threshold. But if you are addicted to a drug (debt) after another drug shot (stimulus based on debt) you get depressed again…This is to say that there is no compelling economic logic to another stimulus or bailout in such a deliberate haste unless you want to continue with your drug problem which is debt and its leverage stimulant effect. It would make much more sense to talk about efficient reallocation of resources to much more productive investments and balance sheets restructuring. We are not in a liquidity trap but in the drug trap. Thus few “simple” recommendations while monetary and fiscal policies are both limited and inadequate: cut unproductive or low-yielding spending and run on surpluses and savings to pay back the different public and private debts.
Drug and stimulus
Posted by: Massimo GIANNINI at Nov 18, 2008 4:14:27 AM
Massimo Giannini, that is exactly the metaphor we need. Thank you.
Posted by: J Thomas at Nov 18, 2008 7:59:28 AM
Paul Krugman hasn't found an economic fallacy he hasn't fallen in love with. The "liquidity trap" is just another example.
Posted by: Brian Macker at Nov 19, 2008 9:18:01 PM
Brian Macker, you have answered the question.
Yes, one can be a liquidity trap denialist. Proof by example.
Posted by: J Thomas at Nov 20, 2008 6:42:32 AM
J Thomas,
Paul Krugman hasn't met a economic fallacy he hasn't fallen in love with. Back when Katrina hit he was singing praises over how it was going to stimulate the economy. That's just plain stupid. If you want to tie your horse to that wagon then go right ahead. The vacousness of the arguments put forth become quite apparent when you have to resort to calling those who disagree with you denialists.
Krugman even found solice in the broken window fallacy in the aftermath of 9/11.
"Ghastly as it may seem to say this, the terror attack—like the original "day of infamy" which brought an end to the Great Depression—could even do some economic good. [...] the driving force behind the economic slowdown has been a plunge in business investment. Now, all of a sudden, we need some new office buildings. As I've already indicated, the destruction isn't big compared with the economy, but rebuilding will generate at least some increase in business spending."
The liquidity trap is just as ridiculous an idea as thinking that wiping out entire towns with a hurricane is good for us, or blowing up a building with planes. It was ridiculous fallacies like this that got us into this mess and they aren't going to get us out.
The problems inherent in fractional reserve banking have not been resolved by moving to a fiat currency. They've only been exacerbated. You are now witnessing what a bank run looks like under a central banking scenario with paper money. It's been done several time before in history and it's ended badly. Hopefully they'll come to their senses but I very much doubt it.
Every economist who has supported central banking and has advocated unsound monetary policy is in part responsible for this mess. Casting aspersions at those who don't buy your con game doesn't make you less culpable.
Posted by: Brian Macker at Nov 23, 2008 11:52:57 PM
