It's a Trap! An Economic Myth Stages a Revival: Caroline Baum

May 27 (Bloomberg) -- Just when you thought deflation was the scariest thing on the horizon, along comes the phony specter of a new threat: a liquidity trap.

In case you're unfamiliar with this concept, its origin owes to the dead British economist John Maynard Keynes, who theorized about the inability of near-zero interest rates to revive the U.S. economy -- restore it to full employment -- during the Great Depression.

As explained by economist Paul Krugman in his New York Times op-ed column on Saturday, when interest rates fall close to zero, ``additional cash pumped into the economy -- added liquidity -- sits idle, because there's no point in lending money out if you don't receive any reward,'' Krugman said. ``And monetary policy loses its effectiveness.''

Krugman, a frequent critic of the Bush administration, warned that the risks of falling into a liquidity-trap ``quagmire'' were high (the Schadenfreude was palpable).

Perhaps Krugman should read the speeches of his former Princeton colleague, Fed governor Ben Bernanke. While it's true that nominal interest rates can't fall below zero, the thrust of monetary policy isn't defined by the level of the overnight rate, which is the chosen policy instrument for most central banks. Even when a central bank faces what the Federal Reserve refers to as the ``zero-bound policy constraint,'' it still has an unlimited ability to print money.

Not Zero-Bound

OK, you say. The Fed can print money, but the banks, which get deposits when the central bank buys Treasury securities in the open market, don't have anyone to lend it to. So there is no multiplier effect to energize the Fed's monetary stimulus.

Wrong. Even when the private sector has no demand for credit, which is hardly the situation today, there is one entity with a voracious appetite: the federal government. With the federal deficit likely to hit $400 billion this year, there's no lack of government bonds for the Fed to buy.

Nobel laureate Milton Friedman used to tell his students at the University of Chicago that as a theoretical argument, the liquidity trap didn't make much sense since the central bank can always expand the money stock. When the central bank puts out more money than the public wants to hold, at the margin someone will spend it.

As a practical matter -- as an explanation for the Great Depression -- Keynes's liquidity trap didn't cut it for Friedman either. The Fed allowed the money supply to contract by about a third, which for him was the cause of the protracted period of declining economic growth, wages and profits.

Soggy String

The idea of a liquidity trap is often expressed by the metaphor of the central bank ``pushing on a string.'' This diagnosis gets recycled whenever the economy isn't responding to low interest rates in the prescribed manner.

The liquidity-trap myth made a comeback in the early 1990s when the U.S., faced with a dysfunctional banking system, required an extended period of low interest rates first to heal banks' balance sheets and second to produce a response in the real economy.

Japan has provided a decade of delight for liquidity-trap theorists. Interest rates in Japan are near zero, economy-wide prices are falling (as opposed to some prices in the U.S.) and the economy is dead in the water.

Unfortunately, the diagnosis is incorrect.

``No country has ever been in a liquidity trap,'' says Allan Meltzer, professor of economics at Carnegie Mellon University and visiting scholar at the American Enterprise Institute. ``Japan is not in one now. Neither is the U.S.''

Misguided Policy

Falling prices and interest rates in Japan say more about mistaken monetary policy than anything else, Meltzer says. The Bank of Japan has the ability to buy more assets, which would increase money growth -- Japan's broad money supply is up a scant 1.4 percent year over year -- and end the deflation.

If the Japanese government ever got serious about cleaning up the banking system -- forcing the banks to write off bad loans, forcing insolvent banks to close -- the BOJ would get some help in its effort.

As far as the U.S. is concerned, Meltzer, who is the author of a new 848-page book, ``A History of the Federal Reserve, Vol. 1: 1913-1951,'' points to several periods when interest rates were at or close to zero, without any liquidity getting trapped.

``In 1954, interest rates were 0.5 percent or below, and we had no problem recovering,'' he says. ``In 1948 to 1949, we had zero interest rates. Also in 1937 to 1938. We had no problem recovering.''

Pink Parrots

Meltzer is equally dismissive of the deflation threat.

``We just reported a GDP deflator of 2.5 percent'' in the first quarter, Meltzer says. The implicit deflator measures price changes in the gross domestic product.

The highest reading in almost two years hasn't stopped a flood of talk and articles on the dreaded deflation ever since the Fed mentioned the risk of falling prices in the statement following its May 6 meeting.

``If Alan Greenspan said the grass is pink, Wall Street economists would see pink grass,'' Meltzer says. ``I like Alan Greenspan, but they all speak as if he's the Oracle of Delphi.''

The Fed chairman hasn't voiced any concerns about a liquidity trap just yet. To the contrary, like Bernanke (and unlike Krugman), he's talked about instituting ``unconventional policy measures'' -- buying long-term bonds -- should the overnight rate hit zero.

And if that doesn't work, I'll bet he has a few strings he could pull (or push).
http://quote.bloomberg.com/apps/news?pid=10000039&refer=columnist_baum&sid=aAve7WbI7aOs

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Desperately Seeking Something — Anything! Krugman’s blind search for a great unraveling continues.

National Review Online ^ | May 28, 2003 | Donald Luskin

It's not easy being Paul Krugman these days. He's got a new book coming out, and he's trying his damnedest to push it. He's all over the talks. He even did an interview with Rolling Stone last week — he's got a cover line sandwiched between "Eminem vs. Jarule: An Underground Rap War Heats Up" and "All-Girl Smackdown: Inside the World of Pro Catfighting." But the timing just isn't working. His book is called The Great Unraveling, but right now most things seem to be raveling. I'm thinking remainder bins.


Think, for a moment, about how good things have been lately, and how hard a catastrophist like Krugman has to work to make them seem bad. The U.S.-led invasion of Iraq was a brilliant victory (Krugman: " ... it did the terrorists a favor ... "). President Bush signs into law today an historic pro-growth tax bill, enacted thanks to the support of cross-over Democrats (Krugman: " ... the administration ... actually wants a fiscal crisis ... "). Even the crisis in corporate malfeasance seems to have been overcome (Krugman: " ... they can get away with even more self-dealing than before ... "). The thing that actually seems to be unraveling these days is Krugman's home base, the New York Times, which is sinking ever deeper into the Jayson Blair maelstrom (Krugman: deafening silence). Krugman has also had his own taste of scandal in recent weeks, thanks to some relentless fact-checking on behalf of The Conspiracy to Keep You Poor and Stupid [Luskin's blog] and the Krugman Truth Squad here on NRO.

But America's most dangerous liberal pundit is not retreating. Instead, he's finding safe harbor in the one realm he believes no one can seriously challenge him: economics.

Atypically for Krugman the economist, his column in last Saturday's New York Times was actually about economics. And it was a big one — over 1,500 words, about twice the length of his usual op-ed for the Times.

The column centered on two economic concepts: deflation and the "liquidity trap." As you might expect, Krugman tried to make it seem that imminent cataclysmic catastrophe is looming. But of course, only he and a few other really smart people can see the danger.

Krugman began with deflation. He introduced the concept using one of his favorite rhetorical tricks: pump up the importance of an issue, then try and make your take on it legitimate by citing the recent comments of a big-time authority figure — one who happens to agree with you. In this case, he cited "a rather ominous report" on deflation issued by the International Monetary Fund. The report, Krugman wrote, has Alan Greenspan "worried" because it shows Germany joining Japan as the next deflation victim.

Krugman cited the report five times. He included shock jargon like "adverse dynamics" and "deflationary spiral" — he even proudly mentioned that the report "draws on my work on the subject."

But hang on — who says the IMF is an authority on deflation? In the past, Krugman himself has called the IMF "chumps," has said it operates "like medieval doctors who insisted on bleeding their patients, and repeated the procedure when the bleeding made them sicker," and has derided their ideas as being based on "bankers' orthodoxy, not textbook economics."

What is deflation, anyway? According to Krugman, it's "a general fall in the level of prices." Okay, simple enough. Now can Krugman tell us what causes it? Yep — the "liquidity trap." Krugman wrote, "Once an economy is caught in such a trap, it's likely to slide into deflation." Now, can Krugman tell us what's so bad about deflation? Yep: " ... the most important reason to fear deflation is that it can push an economy into a liquidity trap."

Whoa. How's that again? Liquidity traps cause deflation and deflation causes liquidity traps? This is why parents pay the big bucks to send their kids to Princeton?

Okay, let's get our money's worth and ask the professor what a "liquidity trap" is. As Krugman explained, " ... what if the economy is in such a deep malaise that pushing interest rates all the way to zero isn't enough to get the economy back to full employment? Then you're in a liquidity trap: additional cash pumped into the economy — added liquidity — sits idle, because there's no point in lending money out if you don't receive any reward. And monetary policy loses its effectiveness."

With interest rates already at zero, Japan would be said to be in a liquidity trap because the Bank of Japan can't lower rates any further. Krugman stated that, in the United States, "with the overnight interest rate down to 1.25 percent, the Fed has almost run out of room to cut."

Of course all this rests on the Keynesian economic orthodoxy to which Krugman proudly subscribes. Krugman and fellow Keyensian travellers expect that a central bank like the Fed can and should rescue the economy from occasional slowdowns by stimulating borrowing activity with artificially low interest rates. Krugman once described it as "the Keynesian compact" that allows brutal free-market economies to operate: "Oh, there are recessions now and then," he wrote. "However, when they occur, everyone expects the Fed to do what it did in 1975, 1982, and 1991: cut interest rates to perk up the economy."

The liquidity trap actually describes a failure of the Keynesian theory of the role of the central bank. It proves that it doesn't work. In most sciences, this would be sufficient to throw out the theory. But Keynesian economics is not a science, it's an orthodoxy — and failure is not an option among the orthodox.

So, evidence of the orthodoxy's failure is given a technical name — the liquidity trap — and itself becomes a part of the orthodoxy in a new, more elaborate version, one that's intensely studied by cultists like Krugman with even more single-minded solemnity than the original. Oddly, John Maynard Keynes himself first described the liquidity trap — but then again Keynes was never so orthodox a Keynesian as his latter-day followers.

If you don't believe the orthodoxy that a central bank is supposed to (or be able to) turn recessionary lead into expansionary gold by lowering interest rates, then that leaves it with a pretty simple mission in life: to preserve and keep stable the value of the currency. This includes preventing events such as deflation, correctly and simply described as "a general fall in the level of prices."

Such a mission consists of little more than printing the correct amount of money to meet the commercial demands of the economy — print too much and you get inflation, print too little and you get deflation. As Milton Friedman said, "Inflation" — or, for that matter, deflation — "is everywhere and always a monetary phenomenon."

With that simple view of the Federal Reserve's mission, I give you economist David Gitlitz, a new Krugman Truth Squad member and my colleague at Trend Macrolytics. Gitlitz correctly argues that the liquidity trap "is akin to an urban legend," and that deflation is nothing to be especially feared just because interest rates are near zero. He wrote in a client report yesterday,

As Fed Governor Ben Bernanke observed in a speech last fall, the Fed has an important tool at its disposal — the monetary printing press — that would allow it to directly inject essentially unlimited quantities of liquidity into the financial system if need be. Fed Chairman Alan Greenspan has reiterated on several occasions that the central bank could easily provide liquidity by jettisoning the rate-targeting regime and focusing its open market purchases on longer-term maturities.

But Krugman knows this. He's recommended that very solution as a fix for Japan's deflation. And he knows Bernanke's views intimately: Earlier this month he bragged on his personal website about "Princeton — where the Fed's Ben Bernanke was department head until a few months ago ... "

So here's the lesson. Just follow the money when Krugman writes things like, "those of us who worry about a Japanese-style quagmire find the global picture pretty scary" or "the risks look uncomfortably high" or deflation "will be very hard to reverse." As new Krugman Truth Squad member Caroline Baum put it in her Bloomberg.com column yesterday, "the Schadenfreude was palpable." That's because Krugman is desperately seeking something — anything! — that's unraveling (other than the New York Times). He's got books to sell.

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Recessions and Booms As Self-Fulfilling Prophesies



Christopher Ragan

McGill University



Spring brings with it new signs of life in the natural world, with tulips and apple blossoms and new little bunnies. This year, at least, the opposite seems to be true in the economic world. Every few days it seems that a major company is announcing large-scale layoffs, and the talk of recession is pervasive. The boom economy of 1999-2000 seems to have suddenly disappeared, replaced by the bust economy of 2001.

Reading the announcements of corporate layoffs, one has to wonder who or what is in the economy's driver's seat. Most Canadian firms announcing layoffs blame the rapid slowdown in the U.S. economy. This makes perfect sense, as Canada exports about 35 percent of its annual output to the United States every year, so a significant slowdown there means a large reduction in demand for our products. But this begs the more basic question: what has caused the U.S. economic slowdown?

All kinds of things can cause a recession. A dramatic increase in tax rates can reduce consumer expenditure and depress business investment. A sudden and persistent increase in interest rates can also do it, as can a sustained decline in foreign demand for exports. The trouble with these explanations is simple — none of these events has happened in the past year. In fact, it is difficult to point to any set of tangible economic events responsible for triggering the U.S. economic slowdown. What remains as an explanation?

Maybe it’s fear. During the depths of the Great Depression in the 1930s, U.S. President Franklin Roosevelt said "we have nothing to fear but fear itself". His initial set of New Deal policies was aimed largely at restoring Americans' confidence. Roosevelt seemed to believe that the health of the economy was so flexible that it could be willed in any direction as long as millions of firms and consumers put their minds to it — like some giant spoon-bending exercise. Can booms and busts be created just because enough people think that way, or is there something more real and tangible driving the economy?

You may be relieved to know that the economy is entirely real and driven by real things. But don't confuse "real" with "tangible". Economic outcomes are the result of decisions made by millions of consumers and firms. Those decisions, in turn, are heavily influenced by expectations about the future. Those expectations are very real, but they are hardly tangible. And this central role of expectations means that the economy is subject to self-fulfilling prophesies.

Here's an example. Suppose a bunch of corporate managers suddenly feel pessimistic about their firms' economic future. For a Texas or Alberta oil producer it may be an educated guess that the world price of oil will fall. For a Michigan or Ontario auto manufacturer it may be a belief that interest rates will rise. For a Maine or Quebec paper producer it may be an informed judgment that foreign demand for its product will fall. The managers may respond to these pessimistic beliefs in slightly different ways for all kinds of reasons, but they will share one thing in common: none of them will embark on new investment projects, and some will probably cancel or delay projects that were already in the works. The result of this pessimism is that investment falls. But that's not the end of the story.

This decline in investment is a decline in the demand for goods and services within the country — the labour and products that would have been used to expand explorations in the oil patch, run the extra shift in the auto plant, or expand the paper mill. This decline in demand, if it lasts for a while, naturally leads supplying firms to produce less output and employ fewer workers, and so production and income fall. This decline in income leads households to curtail purchases and, as sales fall, it leads other firms to scale back their investment plans. And so the vicious circle continues.

If the initial pessimism is widespread, the decline in demand will be large and the eventual reduction in production and income will also be large. We therefore have a perfectly reasonable explanation for a recession. Pessimistic beliefs lead firms to take actions that bring about economic conditions that justify the initial pessimism. In other words, the fear of a recession can itself bring about a recession. Franklin Roosevelt was right about the importance of fear. But there is nothing here that is mystical, nothing "unreal". Expectations are crucial to decisions and thus to economic outcomes, and expectations are real — they are hard to define and measure, and are often hard to explain, but they are real.

The most unsettling thing about the role of expectations in the business cycle is that the expectations can start off being utterly baseless and end up being completely sensible — "rational expectations" in the lingo of economists. In our example the initial pessimism did not have to be based on anything solid. Perhaps there was no good reason to expect oil prices to decline or interest rates to rise or the demand for paper to fall. The beliefs could have the most flimsy foundations — or be based only on superstition. It simply doesn't matter. What matters is that the pessimism leads to lower investment. And as long as the pessimism is sufficiently widespread, we get a large enough decline in demand to create a recession. The recession justifies the initial, apparently groundless, pessimism.

Fortunately, what is true about pessimism creating recessions is equally true about optimism creating booms. This explains why Paul Martin is so concerned today, just as Roosevelt was 70 years ago, with the level of consumer and corporate confidence. You've noticed how often Martin tries to "talk up" the Canadian economy. As long as confidence is high, consumers can be trusted to keep on spending and firms will continue their investment projects. With demand remaining high, firms will respond by increasing production, and the greater income and economic activity will justify the initial bit of optimism. This is the self-fulfilling prophesy working in the other direction — a virtuous circle.

So next time you hear Paul Martin trying courageously to talk up the Canadian economy, even in the midst of widespread corporate layoffs, you can understand what he is trying to do. And you should sympathize with the enormity of his task. Given the existing U.S. slowdown and the resulting decline in demand for Canadian exports, it's going to take a large increase in Canadian investment and consumption to keep the Canadian economy on an even keel. Martin is hoping that lots of positive talk, combined with the income-tax cuts put in place last year, will be sufficient to do the trick. Unfortunately, Paul Martin may face one challenge too many. Martin may be able to keep 30 million Canadians confident about their future. But unless someone is keeping 300 million Americans equally confident about theirs, Martin's efforts may be wasted.

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