Arnold Kling  

Morning Crankiness, Nobel Laureates Edition

Examples of the PSST Perspecti... Critical Thinking on the Holoc...

I am a bit "off" this morning. Ordinarily, my philosophy is "catch them doing something right." If you try to correct people when they do something wrong, they just take offense, and you accomplish nothing. But, nonetheless:

Nobel Laureate Paul Krugman writes,

If you had told most people, back in 2007, that the federal government would soon be running budget deficits in the vicinity of 10 percent of GDP, most of them would have predicted soaring interest rates...But it hasn't happened

After all, interest rates are what the liquidity trap is all about.

He could have written the same thing in 1983. Many people predicted that the Reagan deficits would produce soaring interest rates. The deficits appeared, but the 10-year interest rate peaked before the Reagan tax cuts took effect and plummeted in the latter half of 1982, in spite of then-record deficits. (see graph)

Would Krugman say that this proves that we were in a liquidity trap in 1982? I assume he would say "No, of course not," but he has become such a Johnny one-note on the subject of liquidity traps that I really cannot be sure. He is probably about as far out on a limb on the liquidity trap as I am with PSST, except that he is more insistent than I am that he is right and the rest of the world is wrong.

The way I see it, 2011 is like 1982 in that foreign capital is what is helping to keep interest rates down in the United States. I would call it the "international safe haven trap" if I would call it anything.

When you read the phrase "liquidity trap," you should think to yourself, "a situation in which it has become impossible for a government to debase its fiat currency." That should help you to understand why so few of us believe in liquidity traps.

Andrew Leonard writes,

the current White House team is stocked with veterans from the last big budget showdown, so it is at least possible that they know what they are doing.

In his telling, the President is not being passive. He is being passive-aggressive.

I keep going back to the joint press conference of Nobel Laureates Bill Clinton and Barack Obama a few weeks after the 2010 election, where President Obama walked out. There was a memorable photo of President Obama with his back to the camera (and to the press and to the country) as he left the stage. It occurred to me at the time that the message was, "You don't give me the adulation I have come to expect, so I don't care about you any more." What looks to Andrew Leonard like strategy looks to me like somebody pouting in the wake of a blow to his ego.

Finally, Nobel Laureate Michael Spence, along with Sandile Hlatshwayo, writes,

If a relatively open global system is to survive in a world where nation states are the principle decision makers, it will have to be managed and guided not just to achieve efficiency and stability (important as these goals are), but also to ensure that its benefits are distributed equitably between and within countries.

This is the way the vast majority of economists and policy wonks write and think. Note the passive voice "will have to be managed," which in practice means, "give people like me more power." They are telling us that we need to make the distribution of economic outcomes more equal, and in order to do that we have to make the distribution of power more unequal.

The widely-unread Unchecked and Unbalanced tries to make the point that people are at least as entitled to worry about inequality in the distribution of political power as they are to worry about inequality in the distribution of wealth.

Thanks to the indispensable Mark Thoma for the various pointers.

Comments and Sharing

COMMENTS (24 to date)
Ed writes:

"That should help you to understand why so few of us believe in liquidity traps."

Who's "us"?

Also, for you non-believers, how do you account for Japan over the last 15 years? Large and growing national debt, persistently low interest rates and negligible reliance on foreign lenders.

I understand if you want to argue the US is not in a liquidity trap right now - I'd disagree with you, but I'd accept your point of view - but really, if you needed the economics equivalent of a missing link to prove liquidity traps do occur, Japan is right there before your eyes, has been for 15 years.

James Oswald writes:

Every time you mention one of your books, it carries the adjective "widely unread/unappreciated/etc". I read From "Poverty to Prosperity" and I thought it was pretty good. All authors want their books to be more widely read, but talking about how no one likes your books isn't a good marketing strategy.

James Oswald writes:

@Ed: Japan is a great example of how a central bank can nullify the impact of any fiscal stimulus. If the BOJ targeted 3% inflation instead of 0%, they wouldn't be in a liquidity trap.

joe greav writes:

real interest rate increased substantially

Ed writes:


But you agree there is such a thing as a liquidity trap?

I too believe that the right policy mix can extricate a country from a liquidity trap (not easy, but possible), but Dr Kling is saying there is no such thing as a liquidity trap. That or he has not been too clear when he said he doesn't believe in them.

G Bailey writes:

[Comment removed pending confirmation of email address and for policy violations. Email the to request restoring your comment privileges. A valid email address is required to post comments on EconLog.--Econlib Ed.]

James Oswald writes:

Liquidity traps are like Giffen Goods. They exist in theory, but it's hard to find them in real life. I agree with Kling that they cannot exist with a fiat currency. If you can print infinite money, you can create inflation. Interest rates are just a distraction. On a commodity backed standard, they could be a liquidity trap as prices adjust downward.

tanstaafl writes:

Hi Dr. Kling,
I came here after reading Krugman's response to your post. I must admit I am confused by both of y'all. In 1982 Volker cut the Fed funds rate from 14% to 10%--a pretty big cut--and the ERTA Reagan tax cuts were also being implemented. 1983 was a very good year for GDP. I would guess that the dual monetary and fiscal expansions had something to do with this, showing that monetary policy was effective and the liquidity trap did not apply? Please correct me if I have made an error somewhere.

Eric Dowty writes:

Mathematically there is a very simple relationship between market interest rates and central-bank rate:

That is, a linear regression equation with two terms for current and past central-bank rate. With addition of a single risk term (which can a yield difference or unemployment rate), this gives R-squared of over 95% for US bonds. This applies in all times since 1919, period. Deficits and inflation mathematically add nothing to the relationship.

Krugman thinks he can explain interest rates with inflation, real rates, deficits, liquidity traps, etc. etc. He has got the right answers recently, but how about during the Depression, and WW II and afterwards? Others make claims about the effects of inflation and deficits which don't explain anything currently or over time.

Do any of these economists, who can't agree among themselves, understand what influences interest rates? They should start with trying to understand how central banks influence rates, since that is empirically the major factor.

pgl writes:

Krugman's reply to this nominal confusion was actually the story that Greg Mankiw put in his 1st macroeconomic textbook. I would have hoped you had read and remembered Greg's account of the Reagan crowding-out.

Mike Huben writes:

Paul Krugman's article, Reagan and Interest Rates, claims that Kling needs to "look at real, not nominal interest rates".

That seems like a rather childish error on Kling's part.

economistdunord writes:

Exactly, PGL.

Arnold's reference here to the Reagan years in this way is downright bizarre, and feels like a politically-motivated disingenuous stretch a la Mankiw.

Sorry to see it.

Jameston writes:

[Comment removed pending confirmation of email address. Email the to request restoring your comment privileges. A valid email address is required to post comments on EconLog.--Econlib Ed.]

eclectic observer writes:

Gee, since my macro-money&banking education was pre-Reagan, I guess I'm innocent.

The truth is that MV=PQ still holds and when M goes up, P doesn't and Q is down but moves only slowly mathematically then V must be low (or lower than before. In other words the nonsense that velocity of money is always constant just isn't holding today. So, we are in a liquidity trap. I realize that the monetarists who would like to believe that only quantity of money matters don't like that idea.

j gabos writes:

In addition to the problems noted by other commentors, I'm not sure that a decrease in the 10-year constant maturity rate from just over 14 to 10.5, quickly rebounding to 12 and then to 13, counts as "plummeted." If you scale a graph from 8 to 16, yes, a decline of 3 points in 6 months looks dramatic. In reality, not so much.

sherparick writes:

I really get tired of the implicit of "deep, dark, undemocratic" leftist conspiracy meme that Mr. Kling and so many libertarians suggest. They base this on an unfortnate affection so many academics feel for the "passive" form. It is not a conspiracy against democracy, it is just bad gammar.

If Professor Kling fears the overmighty state, he has to thank the work of Reagan and the 2d Bush for building the current National Security Leviathan. Furhter, within it, I don't believe either academics, the poor, or even the middle class have much political power. All key decisions, by both parties, seem to benefit an Oligarchy made of billionaires, Generals, and wealthy media celebrities. The same people who have gotten most of the money these last 31 years.

Finally, I note that I am often disappointed frequently by the President's actions, from the opposite political pole of Professor Kling, but I claim no insight on his motives or emotions since I am not personally acquainted with the man. What Professor Kling takes as personal insult, I can only observe that in the context of the moment. He was trying to persuade House Democrats to accept the tax deal he had negotiated with the Republicans, a deal most of them disliked. He used Clinton to make the deal more palatable. And I assumed that he did it because 1) he probably thought it was the best deal he could get that would help the economy in the near term and 2) he is probably well aware that the fate of his reelection is tied to the economy. If the economy does well, he does well. The only motive I suspect is true of most politicians is that they want to win elections.

I also remember the period 1982-83, because even though Volker cut nominal rates of interest, Europe remained very unhappy because nominal U.S. rates remained higher than nominal European rates, causing pressure on their currencies. And the resulting strong dollar, although great for me living in Germany, continued to hurt American industry that was in competition with foreign suppliers. And of course Reagan's tax cuts and expansion of military spending was classic Keynsian Fiscal policy, although never acknowledged by you and all the other Fresh-water economists. I think it is the differences bewteen the early eighties when interest rates went from the high teens to the low teens, and now where interest rates for short term rates are esenntially "zero," is what Professor Krugman sees as the clear evidence of a "liquidity trap" now, and there not being one in 1982-83 when Money Market funds earned better than 10% nominal interest, but where because of inflation near 10%, the real interest rate was close to zero.

pgl writes:

There have been other papers - one published in AER - that have been similarly confused about the Reagan deficits and interest rates as I note here:

Ricardian Equivalence? Hmmm. National savings did fall in the 1980's, which is the classical explanation for the rise in real interest rates. And Evans got this paper published in the AER?

Yancey Ward writes:

How sure are that P hasn't moved? How sure are we that we even know what Q is these days?

Widgetmaker writes:

Looks like Krugman nailed ya, professor. Be glad that those on the left are not as snarky and mean spirited as their counterparts on the far right (although this message isn't all that nice).

christy writes:

Krugman responds here - and persuasively

I think a failure to respond in turn by Prof Kling ought to be interpreted as an tacit admission that he is has the worst of this argument. I don't mean that in a school yard scorecard kind of way. This is a very important question/issue with real and significant policy implications. If Prof Kling can't offer a reasonable response then he should link to someone who can - or accept that he is wrong on the issue

[You can find Arnold Kling's response in his next post, at and also in --Econlib Ed.]

aaron writes:

Expenses that a person would generally consider non-discretionary are rising relative to disposable income.

It's a liquidity trap in the sense that food and energy displace spending on core items and drives the demand for savings up and debt down. While decreasing people's ability to save and invest.

ryan writes:

bill clinton is not a nobel laureate.

chris murphy writes:

Contra your response to Michael Spence, making the distribution of economic outcomes more equal need not make the distribution of power MORE unequal. Indeed, given the current disproportionate power of the financial elite and multinational corporate upper management trying to make economic outcomes more equal is likely to make the distribution of power MORE equal by taking power from precisely these groups.

Full Employment Hawk writes:

"10-year interest rate peaked before the Reagan tax cuts took effect and plummeted in the latter half of 1982, in spite of then-record deficits."

A classic example of money illusion; focuses on the effect of fiscal policy on nominal interest rates instead of the relevant real interest rates.

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