Arnold Kling  

Robert Hetzel on the Liquidity Trap

PRINT
Reply to Yoram... Eurobanking...

He speaks for me when he writes,


The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money.

I say again that a genuine liquidity trap (and Hetzel shares my narrow definition) is a unicorn--something we have never seen and never will see.

The Fed was very successful at bailing out large financial institutions. It was a failure at maintaining nominal GDP growth. You would think that this would make the Fed highly vulnerable politically. However, the political right protects the Fed by raising false alarms about inflation, thereby arguing for monetary policy to be tighter, not looser. And the political left protects the Fed by insisting that things would have been much worse without the bank bailouts and by insisting that we are in a liquidity trap.

As you know, I do not buy into textbook macro. But textbook macro has a nonzero probability of being correct, and if it is then the Fed ought to set an aggressive target for the level of nominal GDP and do whatever it takes to hit that target.

I favor this as a Pascal's Wager policy. On inflation, my fear is not monetary policy but fiscal policy. As I have said before, hyperinflation is a fiscal phenomenon. See if you can show me a country where the money supply doubled in a year while the budget was balanced or in surplus.

Finally, I want to point out that while the right-wingers who worried about high inflation in the U.S. in recent years over-estimated inflation, if you had bet on the Phillips Curve you would also have underestimated inflation. (My guess is that if you look carefully, you will see that the Keynesians who got their inflation forecast right did so while getting their unemployment rate forecast badly wrong, which says that their Phillips Curves were off.) A crude linear approximation of the Phillips Curve would be that inflation equals 7.5 percent minus the unemployment rate, which would have predicted negative inflation for the past few years. Instead, inflation has been positive. One can counter that the Phillips Curve is very nonlinear (so that each additional percentage point of unemployment now produces very little disinflation), or that inflation is mis-measured, or somesuch. But I would raise the possibility that the recession is about breakdowns in PSST, so that textbook macro is wrong. In that case, there won't be much payback from following the Pascal's Wager policy.


Comments and Sharing





COMMENTS (8 to date)
D. F. Linton writes:

When you say hyperinflation is a fiscal phenomenon, do you mean that it is always the result of bad fiscal policy results in political control of monetary policy and debt monetization? Surely you are not making some "cost push" inflation claim?

Arnold Kling writes:

DF,
You are correct. I am saying that the monetary authorities do not just wake up one day and decide to hyperinflate. They do so because the government has gotten to the point where the only way to pay its bills is to print money.

Jason writes:

You shouldn't talk about textbook Macro being correct. Nobody's dumb simple theory of everything is correct, they are only simplifications. The question is whether it is good enough of a simplification to teach us something important about what is really going on.

You can believe its definitely wrong and still believe it teaches us something about the correct policy at the zero lower bound.

Chris Koresko writes:

Arnold Kling: The Fed was very successful at bailing out large financial institutions. It was a failure at maintaining nominal GDP growth. You would think that this would make the Fed highly vulnerable politically. However, the political right protects the Fed by raising false alarms about inflation, thereby arguing for monetary policy to be tighter, not looser. And the political left protects the Fed by insisting that things would have been much worse without the bank bailouts and by insisting that we are in a liquidity trap.

Please enlighten me here. You say here and have said elsewhere that the fear of Fed-induced inflation is a phenomenon of the political right, and my impression is that this is true. But I haven't figured out why it would be so: what is the reason that a right-leaning person should be more likely to think that the Fed pumping money into the economy will cause inflation?

My naive understanding of supply and demand says lots more money chasing about the same amount of stuff should mean the amount of money per unit of stuff will fall. I think a lot of (most?) conservatives think that way. But you say we're wrong, and recent history appears to bear you out.

So what's going on here? Is it just that right-leaners use naive economics to reach a conclusion that seems reasonable, while left-leaners reject this conclusion because it makes them, as the party mostly in power when these policies were carried out, look bad?

Chris Koresko writes:

Chris Koresko: ...lots more money chasing about the same amount of stuff should mean the amount of money per unit of stuff will fall.

Oops, I meant rise.

Bryan Willman writes:

Textbooks are correct to the extent that they teach us or remind us that incentives matter, that people pay attention to the future, that markets exist, and so on.

These fundamental issues would lead us to think that "liquidity trap" isn't the interesting issue, even if that unicorn does exist.

The real issue is that people with the resources to pursue projects view the likely return as very poor and so sit on their hands. Interest rates at banks are relatively low because demand for new debt by qualified borrowers to use on new or expanded projects is low. Why? I'd like to suggest that "fear, uncertainty, and doubt" in the very broadest sense is a key issue.

By resources here I don't mean just cash or credit-worthiness (though those count) but also control of business resources, connections, technical skills, and so on.

Does PSST explain this? I don't see a specific link, but the dislocations and confusions that cause breaks in PSST would seem to cause reduction in "faith that projects are worth doing"

Pietro Poggi-Corradini writes:

How might NGDP targeting go wrong? What unintended consequences might we expect?

Fralupo writes:
How might NGDP targeting go wrong? What unintended consequences might we expect?

If we knew the answer to that question they wouldn't be "unintended", now would they? ;-)

Comments for this entry have been closed
Return to top