Keynes and the Misspecified Liquidity Trap

by George Hatjoullis

J.M. Keynes’ “The General Theory of Employment, Interest and Money” was not a general theory but rather a series of brilliant insights. Keynes, a financial market speculator as well as a theoretical economist, applied some insights derived from his speculative activities to economic theory with spectacular results. He used the concept of market failure to explain how the labour market could get stuck in an unemployment equilibrium. This is discussed in one of my pedagogic blogs, “Economics 3: Keynes, market failure and fiscal policy”. He tried to use it to explain why monetary policy could become powerless to affect this unemployment equilibrium through the idea of a ‘Liquidity Trap’, arguably one of the first serious attempts at behavioural macroeconomics. The idea behind the liquidity trap is that efforts by the central bank to increase the stock of money fail to satisfy the demand for money as a store of wealth. Sound familiar? However, Keynes’ explanation as to how this might arise was misspecified.

In the ‘General Theory’, Keynes introduced the idea of holding cash as part of a portfolio of assets; the speculative motive. If asset prices are expected to fall, then cash holdings rise and vice versa. The asset that he focused on was the bond and the risk he identified was interest rate risk. If interest rates are expected to rise prices will fall and holding cash makes sense. In a liquidity trap the fear of interest rate increases becomes so intense and widespread that the demand for cash becomes infinite and the central bank cannot increase the supply sufficiently to meet this demand. In the modern context this makes little sense as an explanation for perfect liquidity preference.

The idea that the demand for cash and near cash, risk-free assets can exceed the ability of the central bank to meet, and thus creates conditions for a deflationary bias, is central to the series of blogs “Understanding the Great Deflation…’, but it has nothing to do with fear of interest rate increases. There are four broad types of financial risk; inflation, interest rate, credit and equity. Inflation risk refers to the real value of nominal assets depreciating as goods prices rise. Interest rate risk is the risk of asset prices falling (e.g. bonds) as interest rates rise. Credit risk is the risk that a financial contract will not be honoured (default). Finally, Equity risk is the risk than an enterprise will fail. The four risks are not independent but at any time one or other may dominate the psychology of markets. From 2008 it was credit risk that dominated and still dominates.

The ‘Understanding the Great Deflation..’ series of blogs basically attempts to correctly specify the notion of the liquidity trap. This does not detract form Keynes’ brilliant insight. Perhaps interest rate risk was the type of risk he was most familiar. The important thing is that market failure can lead to the monetary system getting ‘stuck’ at a suboptimal level of activity. This does seem to be happening at the moment and on a global scale. Keynes’ suggested fiscal policy as the way to break the logjam but the ideology of austerity has closed this option. If the global economy falls into a suboptimal ‘equilibrium’ level of output and fiscal policy is not available and monetary policy is ineffective, then a deflationary bias is inevitable and will persist until a new tool is applied. The only remaining tool is monetary financing (a constant theme of my economics blogs) but this is taboo. Policy makers, we have a problem…