Monday, May 13, 2013

As Paul Krugman Pats Himself on the Back

Paul Krugman informs us today:
As far as I know, among basic textbooks only Krugman/Wells even talks about the liquidity trap; certainly we were the only one talking about it before 2008. And the whole discussion of inflation expectations and monetary policy in a liquidity trap as a sort of inverted version of the usual credibility problem — in fact, the whole revival of the liquidity trap as a modern concern — dates from this paper (pdf). 
This isn’t purely self-promotion (although obviously that’s part of it). I do think that one reason I’ve done pretty well in tracking this ongoing slump is that I’ve been thinking about liquidity trap issues for a very long time, years before almost anyone else.
OK, [...]I’m wrenching my arm patting myself on the back...
So what is the big deal about this liquidity trap that no one, other than Krugman and his wife, was talking about "before 2008"? Murray Rothbard, who died in 1995, actually destroyed the concept decades ago. Bill Anderson explained in 2010:

While Krugman never is going to admit that one can legitimately criticize his positions, nonetheless I do believe it is instructive to look into this "special Keynesian Case," better known as the "Liquidity Trap." Because I include Krugman's explanation above about this particular set of circumstances, and even though he does not identify it as a "Liquidity Trap," that is what he is describing. 
My counter arguments will feature Murray N. Rothbard, who was the best-known Austrian economist of the late 20th Century after F.A. Hayek. In fact, Rothbard deals directly with the "Liquidity Trap" theories both in America's Great Depression and his tome, Man, Economy and State. In America's Great Depression, he has this to say about the "Keynesian Case":
What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers' goods prices falling faster than do consumer goods' prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned "classical" speculation on price changes. This expectation, far from being an upsetting element, actually speeds up the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from "speculative" hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.
Understand that Rothbard and Krugman are arguing from two very different vantage points. Krugman sees deflation as tragic because he believes that it will lead to a downward spiral in which falling factor prices mean lower absolute incomes, and lower incomes mean less aggregate demand, and the beat goes on.

Rothbard, on the other hand, believes that deflation can be positive because it means that the true relative values of the factors are getting into balance, and are shaking off the distortions that occurred during the inflationary booms. Deflation, in Rothbard's view, means that the previous malinvestments are being cleansed from the system, and that a recovery based upon real values of factors can begin.

Obviously, the two cannot be farther apart. Krugman sees everything in aggregates (Y = C + I + G + [X-M]), while Rothbard views the economy as being a complex web of capital, labor, and other factors in which entrepreneurs are moving resources in ways that they anticipate consumers will desire. For good measure, Rothbard also attacks the entire Keynesian concept of "Liquidity Preference," which is a nice way of saying that during deflation, money increases in value relative to other factors, so that people want to hold more money.Rothbard writes: 
The final Keynesian bogey is that people may acquire an un­limited demand for money, so that hoards will indefinitely in­crease. This is termed an “infinite” liquidity preference. And this is the only case in which neo-Keynesians such as Modigliani be­lieve that involuntary unemployment can be compatible with price and wage freedom. The Keynesian worry is that people will hoard instead of buying bonds for fear of a fall in the price of securities. Translating this into more important “natural” terms, this would mean, as we have stated, not investing because of expectation of imminent increases in the natural interest rate. Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite since people must always continue consum­ing, whatever their expectations. Of necessity, therefore, the de­mand for money could never be infinite. The existing level of consumption, in turn, will require a certain level of investment. As long as productive activities are continuing, there is no need or possibility of lasting unemployment, regardless of the degree of hoarding.
Indeed, Rothbard believes (and so do I) that there really is an alternative explanation for what Krugman calls a "Liquidity Trap," and that further borrowing and spending by government only will exacerbate the current situation


  1. The biggest reason why the Keynesian followers have an issue with understanding why their policies and theories are so wrong are not just related to their hardcore reliance on aggregate data, so much as just their general misunderstanding of humans themselves. They literally believe that all people are greedy and are hoarders of money. Saving's is hoarding to them, but to the rest of the world it is capital accumulation.

    1. I think the single biggest reason why Keynesianism has survived is the strawman version of Say's law that Keynes espoused in The General Theory. Keynes's version, that "supply creates its own demand," has haunted economic theory for decades, and is the basis for the theory of there being a "lack of demand" which calls for government intervention. The correct version, "supply of x constitutes demand for y, z, etc." cannot be refuted, and shows that there can be no "general over production" (an over production of x would just mean there wasnt enough y with which to purchase it. also, prices adjust.) which would require stimulus and government management of the economy.

  2. Of course krugman has never seen Rothbard's mention and refutation of "liquidity traps," he openly admits to not reading works by people he disagrees with.

  3. The only reason Keynesianism is still supported is because of politics, not economics. Keynesians are not economists, they are politicians.