Grrrrrr. Paul Krugman is stealing my thunder on the interest rate call that wrecked PIMCO and Bill Gross. Like myself, Krugman was loudly declaring that interest rates had no reason to rise when QE2 ended in 2011. Rates fell after QE2 ended, fell a lot and Gross never quite regained his footing. The rest is history. So Paul Krugman was dead right. He said we were in a liquidity trap and that people preferred to hold money and that that meant traditional monetary policy wasn’t working. And since the economy was weaker than expected then it meant that the risk was not rising inflation, but low or falling inflation and that meant rates would remain low despite the end of QE2.
What I was saying at the time was different. I said QE didn’t have much of an impact on interest rates to begin with because it was a simple asset swap of safe assets for safe assets. That is, QE is like swapping a savings account (t-bonds) for a checking account (cash) and since this didn’t change the flow of funds in the economy then there was little reason to expect a change in the composition of the stock of assets to make a huge difference because QE wouldn’t be inflationary. I’ve also said, flatly, that were are not in a Keynesian “liquidity trap” in the sense that Keynes actually thought. Most importantly, the Central Bank never really controls the broad money supply in any meaningful way so this whole concept of the Fed being able to control the economy through interest rate changes didn’t apply in the sense that many economists seem to think.
All of this meant, all else being equal, that the end of QE2 wouldn’t cause rates to rise because the demand for safe interest bearing assets would remain the same in a low inflation environment which meant that people would simply gobble up more T-bonds as they were issued or they’d remain indifferent as QE2 ended. In other words, so long as there’s low inflation the preference for safe interest bearing instruments is always there whether we’re in a “liquidity trap” or not. So, we agree on the basic story and conclusion, but we disagree on the framework being used to come to this conclusion.
Now, Dr. Krugman has defined the liquidity trap as follows:
“Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.”
That’s pretty friggin’ vague. And it confuses a lot of people because this is not how Keynes thought of a liquidity trap. Keynes said the liquidity trap was a period in which cash and bonds became perfect substitutes:
“There is the possibility … that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.”
In other words, the Central Bank cannot stimulate the economy by printing money because banks and consumers will hoard the cash, interest rates will be uncontrollable and monetary policy won’t work. But this isn’t at all what happened during the crisis and it’s certainly not what’s happening now. The Fed only lost control of interest rates for the briefest of moments during the crisis and the huge demand for certain types of bonds in today’s environment shows very clearly that there’s a strong portfolio preference for interest bearing assets. Ie, there’s actually very strong demand for bonds and, in the aggregate, people don’t want to hold cash. Therefore, cash and bonds are not perfect substitutes. People literally can’t get enough bonds in today’s environments because they want the interest flows from these instruments. They aren’t just holding cash as if their liquidity preferences are low.
Worse, the view that the “money printing” would not work was perpetuated by people who said the Fed would print all this money and the banks would simply “hold it” as though their preference was to not make loans. Ie, they wouldn’t lend it out. In 2008 Dr. Krugman stated this position clearly:
“Here’s one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there’s no incentive to lend out any increase in the monetary base, because the interest rate you get isn’t enough to make it worth bothering.”
Of course, readers here know that this is nonsense. Banks don’t “lend out” the monetary base. The multiplier is a myth. Krugman claims he understood this all along, but his comments clearly convey an erroneous understanding of how banking works. So the liquidity trap view is clearly wrong for the following reasons:
- Banks were never “hoarding” the monetary base or refusing to lend reserves out.
- The Central Bank never lost control of interest rates.
- Bonds are not viewed as perfect substitutes for cash in the current environment.
Therefore, the Krugman rationale for a “liquidity trap” was never quite right even if some of the predictions were right. Yeah, the interest rate channel has proven dysfunctional in the current environment, but not because of liquidity preference, liquidity traps or something like that. More likely, the interest rate channel has always been a pretty weak way to steer the economy and we didn’t realize it until the current crisis.
The real question now is, how long is this myth of a “liquidity trap” going to continue? How long can we continue to say we’re in a liquidity trap when this model is obviously based on flawed thinking? Or better yet, isn’t it now becoming clear that the Fed NEVER really had an omnipotent type control over the “money supply” and the economy to begin with? In other words, has the interest rate always been a poor way to enact monetary policy? I’d say that’s pretty accurate. And either way, it renders the idea of the liquidity trap misguided at best and useless at worst.
NB – I should also add that it’s wrong to say that monetary policy has become ineffective. Yes, changing interest rates has become ineffective, but that doesn’t mean that monetary policy as a whole has become ineffective. I’ve pointed out, on several occasions, that the Fed could enact extraordinary measures which would likely have highly beneficial effects. Policies such as pegging the long bond rate explicitly, buying municipal bonds (thereby financing state government spending) or buying nonfinancial assets in exchange for cash would all have positive economic outcomes in my view. The fact that the interest rate channel has become ineffective is not a sign that all potential actions by the central bank are ineffective.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.