Some Issues with Krugman’s Liquidity Trap

There’s a very important debate going on right now about monetary policy. Namely, how does the Fed unwind QE and what policy, going forward, will mitigate the zero lower bound constraint (ZLB)? At ZLB, money and bonds become perfect substitutes and monetary policy becomes impotent (or at list, this is our current level of understanding). This is the dreaded “liquidity trap” that prevents central banks from bootstrapping economies toward recovery in the aftermath of a recession.

David Beckworth has a fascinating interview with Paul Krugman, who put liquidity trap back on the map with his 1998 paper on Japan. This is a good opportunity to point-out a few problems with Krugman’s framework and mainstream DSGE in general.

  1. No micro-foundations of money demand
    The inconvenient truth about mainstream DSGE is that such models have no place for money (or banks for that matter). This goes back to Hahn’s Money Puzzle and the notion that Walrasian equilibrium is nothing but a model of a barter economy. Economists have used a number of tricks in order to stick money in their models such as money-in-utility, cash-in-advance or search models of money. What’s common among these approaches is that money is largely represented as an exogenous object that facilitates exchange. As a result money demand is simply a plug. The fact of the matter is that money is a credit arrangement between a borrower and a bank that can be created and redeemed upon demand. Without micro-foundations of this relationship and the reasons why savers are willing to hold money, mainstream DSGE cannot claim to be a representation of a monetary economy (nor can it offer insights in regards to monetary policy).
  2. Non-neutrality of money
    Mainstream econ pre-supposes a very mechanistic relationship between money and prices. As the story goes, money is nothing but a veil. In the long-term, prices are fully flexible, hence the economy self-corrects to full employment. In other words, money is neutral with no real effects in the long-term. If you put more money in the economy, prices will simply rise with no real effects. In Krugman’s model, the neutrality of money appears under the guise of a single money motive, whereby agents hold money only for the purposes of facilitating exchange. Only at ZLB, does a second money motive emerge, whereby agents begin to hold money as a long-term store of wealth since money and bonds become perfect substitutes. This story begins to fall apart if we were to assume that the store-of-wealth motive persists away from ZLB even when interest rates are positive. The neutrality of money starts to appear on shaky grounds as we can no longer draw a direct link between money supply and prices. This is exactly what Keynes did when he talked about speculative money demand; however, this insight seems to have been overlooked in mainstream DSGE. The important take-away is that money demand has to be modeled explicitly, which goes back to point 1 above.
  3. Natural Rate of Interest and Full-Employment Equilibrium
    The notion that there is some real interest rate (the natural rate), at which the economy reaches full-employment equilibrium, permeates all of mainstream economics. In Krugman’s case, he talks about a negative natural rate, whereby the central bank is unable to lower rates low enough for full employment due to the ZLB constraint. Therefore, he advocates an inflation-target that enables central banks to impose negative real rates. Alternatively, monetarists like David Beckworth talk about price-level targeting. The underlying idea is the same — agents reduce nominal interest rates by their inflation expectations to derive the expected real rate, and as long as that rate matches the natural rate, the economy will equilibrate to full employment. There are all sorts of problems with this framework — for starters, the natural rate is not micro-founded. But I want to challenge the very notion that an interest rate exists, at which the labor market clears. This goes back to Walrasian equilibrium and the notion that if all other markets are at equilibrium, the labor market, by necessity, also has to be at equilibrium. As I mention above, the Walrasian framework describes a barter economy, where agents have to produce something first and take it to market to trade. We live in a monetary economy, where agents have to go to the bank first in order to create money, and only then can they engage in production and trade. This shift in perspective upends the notion of equilibrium and raises the possibility that a free-market economy can suffer from systemic unemployment regardless of interest rates (or prices and wages for that matter).

What does this all mean? Back to the question of the day — what should be the size of the Fed balance sheet in the age of QE and excess reserves? Academic macro has no answers, basically leaving policy makers blind. This is perfectly encapsulated by Ben Bernanke’s famous quip: “The problem with QE is that it works in practice, but it doesn’t work in theory”. The Fed has to be very cautious with any wholesale changes to policy because we do not understand how the monetary base transmits to the economy. In my view, higher inflation target and price-level targeting are too big of unknowns and should be avoided. Instead, the Fed should gingerly feel its way either expanding or shrinking the size of the balance sheet in an attempt to keep inflation low and steady. And just to leave you with another disconcerting thought, paying interest on reserves actually increases the size of the balance sheet, so the Fed may not have even begun the tightening cycle.