29-07-2003 04:54									#1
	Bad Argument Against Liquidity Trap Support Apolyton buy from Amazon

It's one thing to say that there is no historical evidence of a liquidity trap, but this guys understanding of economics is too poor to critisize Keynes.

quote: Enough nonsense about the liquidity trap By CHRISTOPHER LINGLE Special to The Japan Times Tokyo's cutting interest rates was once the response to borrowing costs being too high or credit too tight. Despite no indications that the financial system is deprived of liquidity, the Bank of Japan and the U.S. Federal Reserve Board continue to hold or push down interest rates. Unfortunately, both the BOJ and the Fed are acting upon a mistaken belief that money must be pumped into the system before a "liquidity trap" develops. The notion of a liquidity trap has a long and dubious history. It was contrived by economist John Maynard Keynes to describe a situation in which low interest rates induce bondholders to express a "liquidity preference" to the extent that it interferes with monetary pumping aimed at stimulating the economy. The logic is that investors will worry that an eventual rise in interest rates will cause them to suffer capital losses as bond prices decline. This encourages an increase in the demand for cash balances (liquidity preference) that is so great that the interest rate cannot fall low enough to stimulate investment. One implication is that rates will not react to increases in the money supply and that economic growth becomes immune to monetary pumping. At very low interest rates, the demand for cash increases to the point that new injections of money into the system are hoarded instead of spent. This means that the portion of wealth held in the form of cash balances becomes so intense that the rate of interest can never go low enough to stimulate investment spending. Given the conditions of Japan's current economic malaise, a liquidity trap may seem plausible. But neither is it the cause of Japan's economic problems nor is it likely to afflict the United States. In Japan' s case, irresponsible monetary policies made Japan's economy and its financial sector deeply dysfunctional. When a liquidity trap is supposedly sighted, the proposed cure is for central banks to print lots of new money to buy up bad loans in the banking system and the overvalued assets of corporations. As paper money floods the economy, negative interest rates occur and prices rise rapidly. The whole point is to boost aggregate demand. Negative interest rates tend to discourage saving by lowering borrowing costs. Inflation, on the other hand, encourages people to buy more today to avoid higher prices tomorrow.

This is not what Keynes proposed. He proposed fiscal policy. He said that monetary policy would have no effect.

quote: Yet attempting to stimulate demand artificially only worsens the overall condition of the economy. Price inflation can sustain output only if it restores profitability to the pool of unsound investments undertaken in response to artificially low interest rates. Rising profitability will happen only if costs fall relative to the monetary value of the output. But this only allows ill-advised investments to continue while encouraging more bad ones, thus setting a course for a more severe downturn in the future.

Austrian School. So this person is against any stimulus at all, not just stimulus under the situation he is discussing.

quote: The notion of a liquidity trap reflects a puzzling and contradictory reversal of the Keynesian notion of the determinants of the interest rate. And not only is his monetary explanation misleading, it also lacks theoretical and historical support. In most of his work, Keynes portrays interest rates as being determined by liquidity preference relative to the supply of money. But in specifying a liquidity trap, he suggests that the demand for holding money is inversely related to the rate of interest.

Keynes did not contradict himself. He never considered the determinants of the interest rate to be hard fast. This is obvious since he suggested that the demand for money is inversely related to the rate of interest during a liquidity trap. The difference is that Keynes said the determinents of the interest are relative to the situation.

quote: By confusing the idea of cash holdings with savings, Keynes thought that increases in savings would reduce investment by reducing consumption spending -- he portrayed investment as depending upon more spending rather than upon increased savings. But it is only savings that can naturally and permanently bring down long-term interest rates.

The long-term interest rate is determined by savings true, but long term savings (investment) is determined by the short-term success of the economy. Anyway, Keynes was not concerned with the long-term. This guy is trying to say that Keynes meant that the long-term interest rate was not determined by savings and that is just too wrong.

quote: It turns out that the conceptualization of the liquidity trap reverses the Keynesian explanation of the determinants of the interest rate. In Keynes' formulation, interest rates are determined by liquidity preference and the supply of money. However, when speaking of the liquidity trap he specifies that the demand to hold money responds inversely to changes in the rate of interest. Few theorists would be bold enough to express causation as running both ways. But Keynes assumes that the demand for cash determines the rate of interest and that the rate of interest is determined by the demand for cash.

Keynes didn't say that causation runs both ways. He meant that deflation would cause a liquidity trap at one point in time, and after that the liquidity trap would cause further deflation. These are two different effects. Each effect has a different cause. No causation running two ways.

quote: Paul Krugman is an articulate modern proponent of the liquidity trap, but he is as confusing as Keynes. Krugman has suggested that when an economy is caught in a liquidity trap, it will slide into deflation. But then he states that deflation can push an economy into a liquidity trap. Like Keynes, he apparently likes to have it both ways. Urging central banks to create inflationary expectations by flooding an economy with money is fundamentally irresponsible. By causing them to misread capital costs relative to future demand, cheap credit causes entrepreneurs to waste capital and savings. While central banks can certainly flood an economy with money, this will not increase the productive capacity of the economy, but it can cause harmful distortions in the structure of production. By forcing interest below market rates, excessive credit formation occurs so that firms are induced to invest in unprofitable or unsustainable projects. Economic booms based on "cheap money" result in a cluster of errors and misguided investments that cannot be completed because there will be insufficient capital in the form of producer goods in the future. All this eventually leads to a profit squeeze when these firms find that returns don't cover rising costs. Eventually unemployment rises and idle capital appears, while consumers try to restore their desired savings-consumption ratio. Despite the logical inconsistencies and complete lack of historical evidence of their instances, the notion of the liquidity trap is likely to survive. Politicians like this fiction since it provides a logical argument to disguise their penchant for irresponsible increases in spending of taxpayers' money. But neither Japan nor the United States can be considered in the throes of this mythological beast. Christopher Lingle is a visiting research scholar at Hitotsubashi University and Professor of Economics at Universidad Francisco Marroquin in Guatemala. His e-mail address is: CLingle@ufm.edu.gt The Japan Times: July 24, 2003

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This guy is a sad excuss for an economist.

	29-07-2003 05:30									#2
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quote: Keynes didn't say that causation runs both ways. He meant that deflation would cause a liquidity trap at one point in time, and after that the liquidity trap would cause further deflation. These are two different effects. Each effect has a different cause. No causation running two ways.

Well, if deflation does cause a liquidity trap AND a liquidity trap causes deflation, then causation does run both ways. Deflation is deflation. It isn't like deflation caused by a liquidity trap is any different from deflation caused by lack of demand for cash. They are both deflation.

I'm not really sure what difference it makes however. A liquidity trap can only occur during deflation (Technically that is. I guess something like a liquidity trap could occur at other times). So I don't really understand what the problem with "dual causality" is. A liquidity trap is bad because it (probably) results in high unemployment, not because it results in more deflation. It would do that, but that isn't the problem. The problem is the misery that it causes.

	29-07-2003 05:35									#3
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quote: Originally posted by Vanguard Well, if deflation does cause a liquidity trap AND a liquidity trap causes deflation, then causation does run both ways. Deflation is deflation. It isn't as if deflation caused by a liquidity trap is any different from deflation caused by lack of demand for cash. They are both deflation.

How could the liquidity trap cause the deflation that came before the it? It couldn't.

quote: Originally posted by Vanguard I'm not really sure what difference it makes however. A liquidity trap can only occur during deflation (technically speaking, I guess something like a liquidity trap could occur at other times). So I don't really understand what the problem with "dual causality" is. A liquidity trap is bad because it (probably) results in high unemployment, not because it results in more deflation. It would do that, but that isn't the problem. The problem is the misery that results from declining production.

The negative effect of a liquidity trap is simply that monetary policy can not be used effectively. So fiscal policy needs to be used.

	29-07-2003 05:38									#4
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quote: How could the liquidity trap cause the deflation that came before the it? It couldn't.

True enough. But what difference does it make? A liquidity trap, by definition, only occurs during deflation. So if you have a liquidity trap, you are in deflation. I don't see how causality enters into it.

	29-07-2003 05:40									#5
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quote: Originally posted by Vanguard True enough. But what difference does it make? A liquidity trap, by definition, only occurs during deflation. So if you have a liquidity trap, you are in deflation. I don't see how causality enters into it.

Just that he misrepresented Keynes.

	29-07-2003 05:43									#6
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Keynes should be used to it by now.

	29-07-2003 06:02									#7
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Well, in fairness to this author, a liquidity trap has yet to be unambiguously sighted, let alone captured and put on display. The closest we come to seeing one in action is Japan over the last decade. And Japan has NOT displayed the symptoms predicted by Keynes.

It is worth noting that Keynes has not been completely flawless as an economist either. It is hardly heresy to question Keynes views on, well, a lot of things.

Which is not to say that I think that a liquidity trap is not something to think about. The reason we have never seen one could just be the fact that Keynes pointed out this particular potential danger of deflation. So modern economists try very hard to avoid it.

Last edited by Vanguard on 29-07-2003 at 06:09

	29-07-2003 06:09									#8
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quote: Originally posted by Vanguard Well, in fairness to this author, a liquidity trap has yet to be unambiguously sighted, let alone captured and put on display. The closest we come to seeing one in action is Japan over the last decade. And Japan has NOT displayed the symptoms predicted by Keynes.

Actually Japan has shown similar symptoms. There is no liquidity trap there, but still monetary policy has failed. People aren't changing their preferences for cash, but they certainly have changed their preference for bonds. Interest rates have been increasing lately while deflation continues. In order for a liquidity trap to occur the whole world would have to be in a deflationary situation.

quote: Originally posted by Vanguard It is worth noting that Keynes has not been completely flawless as an economist either.

Hows that?

	29-07-2003 06:29									#9
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Keynes most glaring errors, of course, are his predictions of the effects of the Versailles treaty. Of course, if you discarded every economist whose predictions don't pan out........

On a note more relevent to this discussion, Keynes' ideas on how depressions begin were incoherent.

I don't want to push this point too far however. Keynes is certainly a great economist. Also I have to admit that this author seems to misrepresent or misunderstand Krugman.

On the other hand, I find it difficult to argue with his overall idea that economists really have no idea what will happen when you drop money out of a helicopter. There isn't much empirical data on this subject, only some plausible ideas.

But on the other, other hand, his assertion that it is irresponsible to take action based only on such plausible ideas is simple minded. Clearly it would also be irresponsible NOT to take action if the postulated circumstances occur.

Anyway, you're right. I agree with your initial post. Don't know what I was complaining about.

Last edited by Vanguard on 29-07-2003 at 06:51

	29-07-2003 11:12									#10
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Thanx for talking

	29-07-2003 11:51									#11
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quote: Originally posted by Vanguard Keynes most glaring errors, of course, are his predictions of the effects of the Versailles treaty. Of course, if you discarded every economist whose predictions don't pan out........

How were Keynes' predictions about the treaty's effects wrong?

	29-07-2003 13:05									#12
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To me the liquidity trap has already appeared in Japan. Dispite the ever lowering interest rate, people have shown no sign of a change in preference in where they place their $.