Friday, April 27, 2012

Economics: Effective demand, liquidity traps and debt deflation

by Michael Roberts

Paul Krugman has laid into Ben Bernanke, the head of the US Federal Reserve, for stopping his previous policy of easy money and quantitative easing.  By pausing, Krugman reckons that the Fed could allow the US economy to slip back into recession: “He has not done remotely enough. The Fed, under its eminent chairman, was supposed to be an important part of the solution to mass unemployment. That isn’t happening.” (

The thing is that Ben Bernanke is not a Keynesian.  He is really a follower of Milton Friedman, the deceased right-wing Chicago economist and adviser to the Chilean dictatorship of General Pinochet in the 1980s.  Friedman started off as a Keynesian, but eventually argued that depressions are caused by the lack of sufficient money supply (the quantity theory of money).  Central banks need to get the right amount of money supply in an economy to get it to grow at full employment: too little and you have a recession or even depression as in the Great Depression; too much and you get inflation.  So recessions are the fault of central banks.

Bernanke agrees with this theory.  As he said at Friedman’s 90th birthday tribute: “regarding the Great Depression, you’re right.  We did it.  But thanks to you, we won’t do it again.”  He meant that the Great Depression was the fault of a Federal Reserve that released too much money into the economy and then took it away too quickly.  Now Bernanke wants to avoid a debt deflation, where debt rises in real terms because inflation turns into deflation in a slump.  But he also wants to avoid inflation.  Right now, at least according to his latest Fed statement last  Wednesday, he is not sure which way the economy is going.  So he is sitting on his hands and pausing on any further quantitative easing.  Bernanke  said in his press conference that his current policy, given that there is inflation, is completely consistent with his old views on the Great Depression.

Krugman wants more action, presumably more QE, as he reckons  the economy is in a Keynesian ‘liquidity trap’, where companies are not investing and households are not spending and instead are ‘hoarding’ cash, even though interest rates are near zero (at least from the Fed) and borrowing is cheap.  For Keynesians like Krugman, government spending is fine under certain conditions: when there is liquidity trap; when there is high unemployment and when the lack of demand persists.  Then the multiplier effect on GDP growth from more spending can be high (see Pontus Rendahl, A case for balanced budget stimulus, 26 April 2012,

The Modern Monetary Theory (MMT) guys reckon that it does not take a liquidity trap to prolong a depression.  If there is no demand for credit, then no amount of leading a horse to the trough will work.  So the MMT guys want fiscal action through more government spending.  As Bill Mitchell put it in his blog ( “The Modern Monetary Theory (MMT) does not rely on the existence of a “liquidity trap” (however conceived) to make a case for the effectiveness of fiscal policy. Paul Krugman and others, who currently advocate the the use of fiscal policy, only do so because they claim there is a liquidity trap which renders monetary policy ineffective. However, in normal times they advocated the primacy of monetary policy.  MMT can demonstrate the ineffectiveness of monetary policy outside of a liquidity trap. The reality is that policy makers have very little idea of the speed and magnitude of monetary policy impacts (interest rate changes) on aggregate demand. There are complex timing lags given how indirect the policy instrument is in relation to its capacity to influence final spending.  Further there are unclear distributional effects – creditors gain when rates rise, debtors lose. What will be the net effect? Central bankers do not know the answer to that question. Monetary policy is also a blunt policy instrument that has no capacity to target specific segments of the spending population or regions.  We always knew that. …  By continuing to see quantitative easing as the solution, the more progressive mainstream economists have also caused the current crisis to be extended.”

That brings me back to my previous post (Paul Krugman, Steve Keen and the mysticism of Keynesian economics, 21 April 2012) and taking it a little further.  Some comments on my last post on Keynesian economics suggested that I had been too harsh on Keynes and his followers, not distinguishing clearly enough between ‘New’ or ‘Post-Keynesians’ who had watered down Keynes so his theory could be synthesised with neo-classical economics.  Keynes, himself, was much more radical, says Krugman.  Well maybe.  Keynes himself considered his ideas as “moderately conservative in its implications”.  But then Keynes changed his views and his opinions on a regular basis.  Once, when questioned about his inconsistency by his neoclassical critics, he said “well, when the facts change, I change my ideas, don’t you?”.  The trouble is it depends on whether the facts have changed or just your view of them.

One of the main issues for me is whether Keynesian claims about the lack of ‘effective demand’ constitute a causal theory of crisis or just a tautology.  Is not the lack of effective demand really a description of a slump rather than its cause?  Paul Krugman, in a little piece called Reading Keynes, tells us that where aggregate demand intersects with aggregate supply, we can find ‘effective demand’ and this equilibrium point could be well below that necessary for full employment in an economy.  This is the key argument of Keynes against the neoclassical school of economics, who claim that supply will create sufficient demand to avoid unemployment.  This is Keynes refuting the fallacy of the so-called Say’s law that claims supply creates its own demand. This is supposed to be startlingly new, although several economists in the 19th century, including Marx, had already shown this.
In his well-known (among economists) attack upon the failure of neoclassical economics to explain economic recessions and particularly the Great Recession (How did economists get it so wrong? 6 September 2009, NYT Magazine), Krugman presents his ‘co-op babysitting’ example. He says “a recession is a problem of inadequate demand.  There isn’t enough babysitting demand to provide jobs for everyone who wants one.”  But this is not an explanation, but a description.  Inadequate demand arises in the baby coop because people hold onto the money rather than buy babysitting services.  This is really yet another refutation of Say’s law.  All it shows is the possibility of a breakdown between buying and selling because of money.  Marx had described that possibility over 150 years ago.  It’s not new.  But in Krugman’s example, there is no explanation of why or when the coop starts hoarding money rather than spending it; it just starts happening.  Krugman puts it down to ‘irrational’ people and ‘imperfect’ markets (the latter, a neoclassical explanation).

It’s the same problem with the explanation of depression as due to a liquidity trap i.e we get to ‘zero bound’ interest rates and there is still no new spending on investment or consumption.  This liquidity trap can be shown by the ‘velocity of money’ in an economy.  Look at this graphic.  It tells the same story as the money multiplier graphic in my last post.

In the Great Depression, the economy becomes ‘stuck’ in a trap of unwillingness to spend – the velocity of money line is well below average.  This is the problem, says Keynes and Krugman.  Yet in the Great Recession, according to the graph, the liquidity trap is not so obvious.  And anyway, why has it happened?  Because there is an unwillingness to spend!  In other words, there appears to be no rational explanation for why the velocity of money drops suddenly in the Great Depression or the Great Recession except that it does.  But in a capitalist monetary economy, such hoarding can be perfectly rational if we connect with a fall in profitability for investment.  Then there is less confidence to invest further and hoarding starts.  Look at the current state of affairs, with US corporations building up huge cash piles and investing relatively less (see my post, Why is US recovery so weak?- look at profitability, 3 April 2012).

The Austrian school of economists argue that the slump in investment is due to previously excessive credit expansion that is now bursting.  The Minsky school says much the same (as does Steve Keen – see my last post).  Those who believe this have attempted to measure the point at which excessive credit or debt becomes the tipping point for a crisis.   The economists Reinhart and Rogoff have done so; the IMF has done so and apparently so has Steve Keen (see my post, Riccardo Bellofiore, Steve Keen and the delusions of debt, 7 October 2011).

Irving Fisher was the ‘debt deflation’ economist of the interwar period.  He reckoned that there were waves of excessive credit or debt, which eventually led to ‘debt deflation’ ie falling prices drive up the real value of debt and so painful deleveraging must follow to reverse the excess. This is the main reason for booms and slumps.  So debt matters.  Krugman seems to recognise that there could be “debt-driven slumps”.  In 2010, he wrote a piece with Gauti Eggertsson (Debt, deleveraging and the liquidity trap, 16 November 2010) that argued an “overhang of debt on the part of some agents who are forced into deleveraging is depressing demand.”  From that debt deflation (Fisher-style), the liquidity trap and the Keynesian multiplier emerge.  And this provides a “rationale for expansionary fiscal policy”.  Krugman called it a Fisher-Minsky,Koo approach to the crisis, although Steve Keen has remarked that he could find little of Minsky in the paper (remember Krugman has little time for Minsky’s financial instability theory).

Yet more recently, Krugman appeared to deny the role of debt in crises.  Krugman says it does not matter in a ‘closed economy’ i.e. one where one man’s debt is another’s asset.  It’s only a problem if you owe it to foreigners.  But the IMF disagrees.  In its latest World Economic Outlook, April 2012, IMF researchers take Krugman to task.  The IMF outlines the evidence that debt does make a difference both to the depth of the crisis and the strength of the recovery: “recessions preceded by economy-wide credit booms tend to be deeper and more protracted than other recessions”  (p96) and “housing busts preceded by larger run-ups in gross household debt are associated with deeper slumps, weaker recoveries and more pronounced household deleveraging“, p115).

Indeed, there is no guarantee that an economy will come out of a slump.  That’s why Fisher misread the slump of 1929.  He thought would be over in a moment, once debt had been cleared.  Instead, it took a war ten years later to do it.  This time too, the clearing of both ‘dead capital’ in production and fictitious capital in finance is going to take a long time.  So we are in what is really a ‘long depression’ as in the 1880s in the UK and the US.  The great boom then  (or ‘great moderation’ now) of 1850-73 (1982-97 now) came to end in a big crash (1873 then, 2007 now), and subsequently it took a series of slumps (1879, 1883, etc or 2008-9) to clear the decks for renewed profitability before capitalism entered a new period of growth from the 1890s onwards. The long depression of the 1880s did not lead to a world war, but to the massive extension of imperialism that helped to get capitalism going (that later ended in war).

So it is no surprise to find that the best way to clear this excessive debt is to default.  A recent study by the IMF on private and public sector debt found that the easiest way to get debt under control in the absence of fast economic growth (current conditions) was to default! (IMF special paper, Default in today’s advanced economies,  2010).

So let’s sum it up.  What is the cause of booms and slumps or economic recessions or depression?  The dominant neoclassical school of economics says any slump is due to imperfections or ‘frictions’ in the market place (namely trade unions or governments disturbing the labour market or monopolies distorting product markets).  In other words, when so-called ‘efficient markets’ are no longer efficient.

Keynesians reckon it is caused by the lack of ‘effective demand’, which happens by chance or by ‘irrational’ behaviour on the part of ‘economic agents’, who suddenly hoard money rather than spend it.  Sometimes this can lead to a ‘liquidity trap’ at ‘zero bound levels’ of interest-rates and so prolong a recession into a depression.

The Minsky school says the cause is an inherent instability in financial sector due to excessive risk-taking that generates a build-up of debt that cannot be honoured.  The Austrian school says this excessive credit is caused by government and central banks creating it.  Both say deleveraging of this debt prolongs a slump.

Some Marxists reckon crises and slumps are not caused by a lack of effective demand or excessive debt or financial instability, but by falling and low profitability in production.  The impact of falling profitability can be postponed by credit (fictitious capital) expansion, but then the eventual slump will be exacerbated by the need to clear this excessive debt.  This is my view.   Other Marxists reckon the crisis is due to ‘the anarchy of capitalist production’ (that’s too vague and too high a level of abstraction as an explanation for me). Or some say it is due to ‘underconsumption’, or a lack of spending power by workers.  That’s pretty much the Keynesian view (just a description of a slump not an explanation).

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