Pragmatic Capitalism

Capital for Living a More Practical Life

The “Liquidity Trap” Theory Was Never Right….

Apparently there’s some confusion over the title of my last post.  Perhaps I should have been clearer.  I am aware that Dr. Krugman and others have been claiming there are no bond vigilantes in the USA.  But not for the right reasons.  Maybe I am jumping to conclusions, but there appears to have been some move in the right direction away from this idea that the “liquidity preference” was of central importance to understanding the rate debate and the impact of bond vigilantes….After all, even Dr. Krugman has mentioned that he “rethought” his model.  And late last year he clearly defined how Japan’s ability to issue its own currency made it different from countries who were users of currency.

Anyhow, most of the mainstream has been working under some form of the “liquidity preference” theory or “liquidity trap” theory to explain why rates have remained low in the USA.  This was the thinking that economic agents were choosing to just sit on the excess liquidity provided via the government and the Fed.  It sounds right in theory, but it’s wrong in reality.

First, the government doesn’t increase the money supply through government spending (already confused?  See here).  It redistributes inside money (bank money) and adds a net financial asset in the form of a government bond.  This improves private balance sheets and is particularly useful during a balance sheet recession, but it’s not the equivalent of firing dollar bills out into the economy (though it does increase the velocity of spending as the government becomes the “spender of last resort” when an economy is stagnant for whatever reason).  Second, when the Fed implements QE they swap reserves for bonds.  No change in net financial assets.  And since banks don’t lend reserves there is no firm transmission mechanism through which this policy can impact the money supply.   In short, fiscal policy hasn’t been the equivalent of increasing the money supply in the traditional “money printing” sense that most believe and QE has most certainly not resulted in an increase in the money supply because the primary transmission mechanism is busted (the lending channel).

So, how does the money supply primarily increase?  It increases primarily when banks make loans which create deposits.  And why has this mechanism been broken?  Because private actors were saddled with debt from the credit bubble and no longer had the incomes to service these debts when the bubble burst.  Private actors weren’t choosing to sit on their liquid balances.  They had no choice either because they didn’t have the incomes to meet their debt obligations or they were banks who ALWAYS sit on their reserves and don’t lend them out…The liquidity trap theory was never right.  And the liquidity preference argument for bond vigilantes was also never right….

* In case you’re still wondering, a liquidity trap is essentially an environment in which economic agents choose to sit on their liquid money balances as opposed to spend or lend them.  The theory posits that monetary policy becomes ineffective in such an environment.  I agree that monetary policy has become ineffective, but not because of the liquidity trap….

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