Arnold Kling  

Liquidity Trap or Statism Trap?

Comment of the Week, 2003-05-2... History of Option Pricing...

In this essay, I take issue with Paul Krugman's claim that the liquidity trap is relevant to Japan and the United States.

Krugman has learned the wrong lessons. He thinks that the bank bailouts are a good thing, that Japan's problem is a "liquidity trap," and that the U.S. also could fall into a liquidity trap.

In my view, Japan's bank bailouts are a policy mistake, the liquidity trap is irrelevant, and Japan's trap is its statist economic model. I hope that the United States can avoid falling into the statism trap.

Just as this essay was being published, Stephen Kirchner's blog made me aware of a very similar paper by Robert Dugger and Angel Ubide.

For Discussion. Dugger and Ubide argue that Japan has become more averse to risk and innovation as its population has aged. Is the United States destined to go through a similar cultural change?

TRACKBACKS (9 to date)
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The author at in a related article titled Arnold Kling on Liquidity Traps writes:
    It is late, so I'll dispense with much accompanying dialogue and go straight to the links. I believe this will be the first of many posts on the subject, given its recent popularity in econo-pundit circles... [Tracked on June 1, 2003 12:29 AM]
The author at in a related article titled Arnold Kling on Liquidity Traps writes:
    It is late, so I'll dispense with much accompanying dialogue and go straight to the links. I believe this will be the first of many posts on the subject, given its recent popularity in econo-pundit circles... [Tracked on June 1, 2003 12:29 AM]
The author at Tim Swanson in a related article titled Domo Arigato Mr. Roboto writes:
    IMF Says Japan Must Increase Taxes To Restore Fiscal Health:The International Monetary Fund (IMF) issued a stark assessment of the Japanese economy this week, warning that the country must rein in its debt by increasing taxes and accelerating economic ... [Tracked on June 5, 2003 4:43 AM]
COMMENTS (25 to date)
David Thomson writes:

Absolutely not. Risk taking is the norm for Americans. Our nation’s ethos and character is premised upon never ending change. Also, many of our so-called senior citizens are not inclined to rest on their past laurels. They will eagerly seek new challenges until the moment of their death.

Oh gosh, do we still have Paul Krugman around to entertain us? He will soon release his book entitled “The Great Unraveling: Losing Our Way in the New Century.” Might this unwittingly be Krugman's autobiography concerning his rapid declining psychological state of mind? Indeed, the title is fantastic. It’s almost like he had me pick it out for him. I sometimes imagine Krugman as a modern day Antonio Salieri screaming in his lunatic asylum cell: “I have killed George W. Bush!”

I doubt very much if Paul Krugman really gives a damn about “liquidity traps.” The only thing that truly seems to motivate him is his contempt for the Bush administration. The man is unhinged and need of help. Does anybody know a good psychiatrist?

GT writes:

I'd be curious if any of Krugman's peers have commented on this. When you have people like Luskin on your side it kind of detracts from the seriousness of your arguments.

Also, I realize that you weren't planning on writing an academic paper but an Op Ed type piece does not seem to be the adequate way to counter the seemingly well-established notion that Japan is in a liquidity trap or pretty close to it.

This may be of interest by the way:

Eric writes:

Krugman is an idiot. But with that said, one of you economist types needs to explain the liquidity trap argument to me. I don't get it.

The claim is that the Fed can either print money or set the Funds rate. It can't do both, because that's like setting the price and the supply at the same time.

So if the Fed starts printing money, it will automatically lower the Funds rate. And if the Funds rate goes to zero, banks have no incentive to lend money. Thus, the liquidity trap.

That's the argument as I have seen it made. It seems to me that it is way too bank focused. Who cares if banks don't lend, no one gets their money from banks anyway. This isn't Asia, and banks don't dominate the US economy.

And it also seems to me that the Fed Funds rate is the least consequential interest rate out there. By printing money, the Fed would lower longer term, more influential interest rates.

Arnold Kling writes:

You can do a liquidity trap without banks. In fact, it's easier in a textbook world with just two assets, money and bonds. The monetary authority buys bonds with money. This causes bond prices to go up, i.e. interest rates fall.

When the interest rate on bonds drops to zero, the public does not want to hold bonds any more, only money. So adding more money does not lower interest rates any more.

Arnold Kling writes:

I'm not sure what you mean by one of Krugman's peers. I have a Ph.D from the same economics department that he does, if that counts for anything.

As far as I know, Krugman has not published his liquidity trap argument in a refereed journal. In contrast, Edward Prescott's paper that I cited in support of the "statist trap" view of Japan was the Presidential address at the American Economic Association. So I would not agree with your characterization of Krugman's views as "generally accepted."

I share your concerns about Luskin. But rather than worry about who is on which side, I prefer to try to work things out as best I can for myself. For example, my article against standardized testing in schools puts me on the "wrong side" from the point of view of many conservatives with whom I might agree on other issues. Nonetheless, it represents my considered opinion.

Eric writes:

It has been a thorn in my side for some time that the US is expected to pull the world economy along. We have made the tough structural changes, during the '80s and '90s, things like tax reform, deregulation, downsizing, re-engineering, etc. that have made our economy so competitive. And everyone else, particularly the Japanese and Europeans, are content to export their way to economic growth.

What the world needs is the Europeans and Japanese to get their own Ronald Reagan, restructure their economies like we did in the '80s, and produce some domestic led economic growth that US companies could export into for a change!

Isn't one effect of the falling dollar to put more pressure on the Europeans to restructure? I believe that will be the primary effect. The strong dollar has been allowing the European Socialist economic model to survive.

JT writes:

Arnold -- thanks for the interesting and thought-provoking TCS article.

Patrick R. Sullivan writes:

From a front page article in the Wall Street Journal by Jathon
Sapsford, (July 7, 1998):

"TOKYO--Debt and recession are hammering Takao Suzuki's machine shop, but his
bankers won't let him fail. And in that regard, he isn't unique: His is only
one among thousands of businesses, big and small, that Japan insists on keeping
afloat--at great economic expense.

"Mr. Suzuki and his company...owe five banks a total of nearly $2 million, more
than 10 times the revenue he expects this year. Yet his banks keep rolling
over his debt and lowering his interest rates even though he is having trouble
paying back his old debts."

Later in the article:

"Japan's refusal to let a lot of companies fail is a big reason behind the
nation's banking woes. By refinancing deadbeats, banks are able to keep loans
out of their bad-debt columns. That's why, when Japan's top nine banks were
forced recently to disclose more of their portfolios, bad loans jumped by $30
million to $90 million.

"In essence, the bailout habit subsidizes uncompetitive companies to the
detriment of stronger companies, stunting the survival-of-the-fittest principle
that is a key element of the market economy. So despite reports of a ruinous
credit crunch, companies such as Mr. Suzuki's keep rolling over their
loans--even as business sours and the debts pile up."

Still later:

"Cultural factors also play into the willingness to lend. Corporate debt
carries little of the stigma in Japan that it does in the U.S. In the years
after the war, bank debt was seen as the conservative way to raise capital;
bond markets barely existed and stock markets were deemed unseemly--and were
closed to most companies anyway. Also Japan encourages high debt by taxing
corporate equity heavily. 'Japanese businesses run on debt,' says Kiyohiko
Kawahara.... 'Debt is the way we do things here.'"

Eric Krieg writes:

Arnold, check out page A20 of the Journal today. Is Portugal an example of how to break out of the statist trap?

If only France, Germany, and Japan could be as bold as Portugal.

David Thomson writes:

I wish the WSJ had put the story on the front page. Portugal kicked out its Socialist government in December 2001. Those clowns just about busted the country. The Conservatives are seemingly doing what it takes to straighten out the mess. Will the same thing happen to Germany or France anytime in the near future? Heck no, the latter nations are still living in La-La Land.

dsquared writes:

Krugman published "It's Baaack!" on the liquidity trap as a Brookings Paper and I believe that those are refereed (ironically, I'm pretty sure that the AEA's presidential addresses aren't!).

More substantively, I think that the paper you linked to is terrible. It's not enough to just say "structural rigidity blah blah blah" without providing actual evidence of how this "rigidity" actually prevents economic activity from being carried out. It would also require a heck of a lot more work than bald assertion to support the premis that "Japan has become less innovative and more risk-averse" over the last ten years; have a look at i-mode mobile phones and tell me they aren't innovative.

David Thomson writes:

“Krugman published "It's Baaack!" on the liquidity trap as a Brookings Paper and I believe that those are refereed (ironically, I'm pretty sure that the AEA's presidential addresses aren't!).”

The real question is whether the left of center Brookings Institution truly represents the beginning and end of all economic wisdom---or are these merely the so-called scholars who dare not dissent from the dogmas of the Liberal establishment?

“"Japan has become less innovative and more risk-averse" over the last ten years; have a look at i-mode mobile phones and tell me they aren't innovative.”

Is this i-mode mobile phone the only innovation that you can point to? What have the Americans achieved during the same time period? Still, the overwhelming evidence indicates that Japan’s economy is on a sharp decline---and there are few signs of a turnaround anytime in the near future!

Arnold Kling writes:

D-squared points to a Krugman article in Brookings. I think that Brookings Papers counts as a refereed journal.

However, Krugman's article is pretty much all pure theory--he puts most of his effort into showing that a liquidity trap is possible in a macroeconomic model with "modern" features (such as international capital mobility).

Prescott's analysis is empirical. It is not terribly sophisticated--in effect, all he is saying is that labor and capital input continue to be high in Japan. But that simple observation may be enough to point toward supply-side rather than demand-side factors in Japan's slump.

dsquared writes:

An email exchange with a pal reveals that the Brookings series that PK published "It's Baaack!" in are probably not refereed, so sorry about that. Although they do sort of count as a journal, and being refereed isn't a necessary or sufficient condition for importance ("Physics Letters" isn't refereed).

I personally believe multi-factor productivity to be a very dubious concept, and I take very great exception indeed to Prescott's use of "a working-age person" as the unit of input of labour rather than "an hour". I also don't understand how discussions about multi-factor productivity could possibly distinguish between a supply-side or a demand-side explanation for a recession; surely national income identities mean that the two are observationally equivalent?

Finally, although I have massive respect for Prescott's two major papers (Kydland & Prescott on time-consistency and Prescott & Mehra on the equity premium puzzle), I've always found his work on depressions to be just dreadful. As Arnold notes, he tends to use very broad-brush empirics, based on pretty indefensible assumptions about aggregation of capital and about rates of profit. I massively disagree that "depression is a relative concept"; any explanation of Japan's problems has to take into account that GDP has *grown* over the last decade at a rate of about 1% per year.

dsquared writes:

The first paragraph above should obviously have contained an apology for my implicit claim that Brookings papers were refereed and I don't quite understand why it doesn't. Sorry.

GT writes:

My point was not to have a competition of credentials. But, refereed or not, Krugman's article on Japan has become a very quoted article by academics writing on the topic as a quick Google search shows (I'm too lazy to get my EconLit CD out).

Since he wrote about this 5 years ago I have to assume that, if your point is correct, by now there should be several academic articles refuting Krugman's point. The link you provided does not seem to meet those standards. So I have to ask where are the articles by the Feldsteins or Mankiws of the world showing Krugman's model is wrong?

I certainly don't equate you with Luskin but, for better or worse, Luskin occupies the same ecological space you do, that of right-of-center online economic commentators. He's a crank but he writes for the National Review which gives him credentials as economic spokesman for conservative economic ideas.

David Thomson writes:

I will still continue pretending to be something of an amateur psychiatrist. It is my adamant conviction that it is a mistake to presume that Paul Krugman is reaching his economic conclusion based on rational thinking. This man has an intense contempt for President George W. Bush and a need to prove that he is bona fide member of the Liberal establishment. Krugman innately senses what will keep the scandal ridden New York Times happy. I even suspect that he would say the exact opposite if it would hurt the President! Success in today's academic world is often about making sure one is on the side of utopian Liberalism.

The stock market jumped significantly today, and there are other signs that the American economy is improving. Krugman’s book may seem ridiculous before it is even released. Our liberal economist is becoming desperate because he is being marginalized. The polls strongly suggest that his nemesis, President Bush, should easily (knock on wood) be reelected in a landslide. Spending time in the wilderness of public opinion could be very difficult for Krugman to endure. Oh well, he can always claim that the economy might be doing fine for the current moment---but in the long run we will be facing Armageddon. What did Lord Keynes say about the long run?

David Thomson writes:

Wow, I coincidentally found this article (via Instapundit) shortly after I posted my previous comments. I think it says a lot about the Paul Krugmans of the world:

“I have led a double life, of sorts. I often wonder: What will they think of me if, or when, they learn that I'm a Republican? Even as I type out these words, I wonder how my teaching career at Vanderbilt will be affected by my "coming out" in this article. I understand the fears of subtle bias that have driven homosexuals and others to keep their secret lives hidden.”

Eric Krieg writes:

GT, do us all a favor and expand upon your Luskin bashing. For why do you say that he is a lunatic? Is it just that he writes for NRO? Is it that he is conservative? Or are there specific examples of his lunacy.

I read the man on NRO and he seems fine to me. But then, I am slightly to the right of Atilla the Hun.

Bernard Yomtov writes:


I am somwhat familiar with Vanderbilt, and I can assure the writer that his teaching career there will not be at all harmed by being a Republican.

The guy may like to posture as a possible martyr to left-wing orthodoxy in the academy, but posturing, and pandering to anti-intellectualism, is all he's doing.

Matthew Wilbert writes:

It sounds as if you think that the existence of multiple interest rates lessens the salience of a possible liquidity trap. I would be interested in your reasoning; it seems to me that if the interest rate companies have to pay is above zero because of the perceived risk that just strengthens the trap.

Also, something I haven't seen much comment on is that there are multiple inflation rates as well, and in the US economy at least the prices that are rising the fastest are medical costs that it is not practical to pay for ahead of time, and hence not likely to have their purchases accelerated by low interest rates. I don't think it is likely that the US will actually go into overall deflation, but I think it is perfectly possible that the durable goods sector could, if it hasn't already, and that as a result monetary policy could become ineffective.

dsquared writes:

I disagree that the existence of multiple interest rates has any relevance to the liquidity trap debate, on a proper understanding of what Keynes was saying. (Note that "on a proper understanding" in this context is doing its usually duty of indicating that this is by no means the consensus view).

The liquidity trap is about hoarding of *money*, not about over-saving in general, and thus the rate of interest on long term government bonds is more or less irrelevant (you do get "Tobin-Keynes" models in which bonds and money enter as separate asset classes, but it is IMO a mistake to believe that these models are better for the purpose of discussing liquidity traps).

Therefore, the only interest rate relevant to the liquidity trap question is the rate of interest payable on assets which are near-substitutes for money, for which the rate on overnight bank deposits should proxy decently. High term structure or risk premia should be analysed as consequences of the liquidity trap rather than as independent factors; it is certainly possible to earn a rate of return above zero in Japanese assets, but *not on money-like assets*. The first word in the term "liquidity preference" has to mean something, and if it means anything, it surely has to exclude consideration of yields on ten year corporate bonds.

Arnold Kling writes:

Matthew and D-squared,
I have to admit that the Tobin portfolio balance model is the one that has stuck with me over the years. In that model, assets are imperfect substitutes, but they *are* substitutes. People want to hold money, bonds, stocks, etc. When the supply-demand balance changes in any one of those assets, all rates adjust to help equilibrate.

I like that model, even if it's not what Keynes had in mind and even if it does not support the liquidity trap.

TIm Swanson writes:

It appears as though this thread is pretty much "done," however I wanted to point out I blogged about this subject last night after bumping into among other things, your discussion:

Marina writes:

In my opinion, such powerful states as Japan and USA woul'd never be suffering from the "liquidity trap". Moreover, the risking is a habitual thing for Americans, no matter what the top did they reach.

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