The Misinterpretation of the Keynesian “Liquidity Trap”
By William Shughart • Sunday August 29, 2010 6:10 AM PDT • 5 Comments
Economists and pundits, who contend that the Federal Reserve System has little room to maneuver in using monetary policy to jump-start our anemic economy, often have claimed that America is mired in a Keynesian liquidity trap, a situation in which the demand for money is unresponsive to changes in market interest rates. After all, those commentators emphasize, the Fed has adopted a target for the federal funds rate (the interest rate charged on overnight interbank loans) of between zero and 0.25 percent. The implication is that further reductions in that rate will have little or no effect on the incentives of businesses to invest in new plant and equipment or of consumers to borrow in order to finance the additional spending necessary to raise GDP growth above the (recently downwardly revised) estimate of 1.6 percent during the second quarter of 2010.
But those commentators overlook or ignore the easily verified reasoning of John Maynard Keynes, who defined a liquidity trap in terms of long-term rather than short–term interest rates. The long-term (ten- or 30-year) rate on Treasury securities now runs at about three percent, meaning that the Fed still has arrows in its quiver. Unfortunately, however, those arrows, the use of which would demand the central bank engage in further “quantitative easing”, requires it to purchase more under-performing, “toxic” assets from banks and other financial institutions that lent money to homeowners who could not repay their mortgages. Engaging in such transactions places more bad debts on the Fed’s balance sheet, constrains its ability to conduct monetary policy in the future and raises the specter of higher rates of future price inflation.
In his recent speech at Wood’s Hole, Wyoming, Fed Chairman Bernanke was right to say that economic recovery cannot depend solely on the policies of the central bank over which he presides. But the fiscal discipline (spending and tax cuts) required to achieve that goal is incompatible with the vote motives of incumbent politicians or their challengers for political office.
In consequence, the United States will not return to genuine economic prosperity for years to come. Americans ought to be grateful if a “double-dip” recession is the only price they are forced to pay as the result of recent monetary and fiscal policy choices. It would be far better to make the Bush tax cuts of 2001 and 2003 permanent, to reduce the tax rate on corporate income and estates to zero, and to limit government at the federal level to the powers granted to it by the people and the Founders of our compound republic.
America will be able to reclaim the path to prosperity only if the federal government and its central bank get out of the way.
Tags: Budget and Tax Policy, Federal Reserve, Inflation, Money and Banking 
I stumbled onto this site at AntiWar radio and Robert Higgs. Then I find this.
This guy is way off in his way of thinking. Believe me, what he calls “Third World” politics is Latin American nationalism which is anathema to the large capitalists in this country and their petty yet bloody puppet oligarchs in Latin America. There is no incompatibility with productive and economically vibrant societies and repudiation of oligarchies and imperialism; in fact, they go hand in hand if you get down to it.
I’m surprised to find this garbage on what I thought was a straight-shooter, insightful and for the people institute.
Maybe you should read my blogs.
zaknick | Aug 29, 2010 | Reply
I am not Bob Higgs.
William Shughart | Aug 30, 2010 | Reply
” It would be far better to make the Bush tax cuts of 2001 and 2003 permanent, to reduce the tax rate on corporate income and estates to zero, and to limit government at the federal level to the powers granted to it by the people and the Founders of our compound republic.”
The Washington Post just had a conversation with several business leaders, and their responses to everything was the same. “Low consumer demand is why we’re not hiring. We can borrow 3 billion dollars for 2% interest, so what? We have nothing to buy.”
So, given that easy money is available to anyone who wants to invest, I’m confused how the Bush tax cuts, (and be honest, you mean the tax cuts for the rich, no one is talking about removing middle class tax cuts), is going to increase investment or consumption. The top 1% own about 34.6% of the wealth of the United States, the top 10% own 60% of wealth, so you have a massive amount of money in the economy that is just sitting around and being used on speculation, trading futures, betting on bank failures, inflating bubbles, and not contributing to the actual economy in any real or meaningful sense. So the goal then is too... funnel more money to the richest people in the World? That won’t actually do anything meaningful in the economy since the people who benefit aren’t the ones that business leaders are worried about in their demand equations. Ditto on estate taxes.
Reducing corporate tax will eventually help out, it will pull jobs from overseas back home and increase investment at home. Score one point there.
Shifting government functions to state and local areas will increase state taxes, which are already highly retrogressive. Shifting taxes to state and local levels will increase the tax burden on low-to-middle income earners, decreasing demand yet again. The only exception is if you believe that savings from a local/state government is so great that even the disproportionate tax burden will be lower than under federal levels. Maybe half a point there because it could be true, could be false.
1.5 out of 4 on the economic scale.
NoMan | Aug 30, 2010 | Reply
To NoMan:
Given that only about 50% of Americans actually pay income taxes, any take cut must benefit “the rich”. But all of the economic evidence suggests that reductions in tax rates at the upper end of the income distribution actually generate increases in federal income-tax revenue.
Estate taxes fall more heavily on those earning moderate incomes. Bill Gates and Warren Buffet can easily avoid such taxes by setting up charitable foundations while they are still living. The estate tax bites most heavily on “family” farmers and the owners of small businesses. Corporate income is taxed twice, once at the corporate level and again when corporate income is distributed as dividends to shareholders, most of whom are not “rich” in any meaningful sense.
Businesses hesitate to invest largely as the result of the ill effects of the current administration’s economic and social policies.
I agree with you that reductions in federal tax rates will create openings for tax increases at the local and state levels. But the main lesson here, in my judgment, is that public spending is out of control everywhere.
William Shughart | Sep 2, 2010 | Reply