Bill Mitchell: Keynes vs. Krugman on the Liquidity Trap

     I looked at his blog on Krugman's liquidity trap before but didn't get into what Keynes' definition of a liquidity trap was-in Mitchell's view. That post was more the argument about ideology and science in economics-I think that you never get totally free of ideology but that doesn't mean economics isn't useful nevertheless. 

     http://diaryofarepublicanhater.blogspot.com/2015/06/bill-mitchell-weighs-in-on-economic.html

     So let's get into it. It's pretty well known-I'm understating things-that Krugman's view is that the liquidity trap is a problem that develops at the zero bound for nominal interest rates. 

     However, Mitchell argues that Keynes' liquidity trap was quite different. 

     "In the Classical theory, money was just a transactional commodity with no special characteristics other than to ease exchange. People exchange in real terms (based on perceptions of real use values) and the introduction of money was of no particular import to those valuations. It just eased the so-called problem of barter where the double-coincidence of wants might be absent (the baker doesn’t want her plumbing fixed and the plumber prefers fruit!)."

    "But for Keynes, money was special and “plays a part of its own and affects motives and decisions and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted, either in the long period or in the short period, without a knowledge of the behaviour of money ebtween the first state and the last” (taken from his book “On the Theory of a Monetary Economy”, page 216)."

     "In the Chapter 17 (Section III) of the General Theory, Keynes wrote:

Unemployment develops, that is to say, because people want the moon; — men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.

    "In other words, the increased demand for money to ease uncertainty doesn’t produce any real goods and services which would employ people, unlike, say, the increased demand for motor cars."

    "So money is a special commodity."

    "Keynes argued that monetary authorities can normally:"

… purchase (or sell) bonds in exchange for cash by bidding the price of bonds up (or down) in the market by a modest amount; and the larger the quantity of cash which they seek to create (or cancel) by purchasing (or selling) bonds and debts, the greater must be the fall (or rise) in the rate of interest.

    "He is referring to ‘open market operations’ here which have been normal liquidity management operations of central banks. Please read my blog – Budget deficits do not cause higher interest rates – for more discussion on this point."

    "But there is a point where people will only wish to hold cash and will eschew the purchase of bonds, thus rendering the capacity of the central bank to modify the interest rate ineffective."

    "And in that sense, monetary policy becomes ineffective as a means of altering the level of total spending in the economy."

     http://bilbo.economicoutlook.net/blog/?p=31112

     So money is special and the LT can develop with interst rates considerably higher than zero if there is no further demand to hold bonds-which can develop whenever the market believes that bond prices have hit a top. 

    Here Mitchell says that Krugman is not wrong on Keynes-but that basically Keynes was also wrong and MMT is right. 

    "So there is some merit in considering that Keynes’ early work was focused not on counter-stabilising policies in a crisis but rather setting in place an institutional structure that would provide for stability in domestic and international monetary conditions."

    "He also believed that large-scale public works, for example, were an important policy intervention that governments could use to break a recession arising from a deficiency of private spending."

    "He clearly showed that the capitalist monetary system could become trapped at production levels which generated mass unemployment and required an external spending intervention from government."

    "Does this mean that he was supporting fiscal deficits in the same way as Modern Monetary Theory (MMT)? Not really, he considered that the expansion on the public expenditure side would via the multiplier expand output and employment and tax revenue."

    "In his Essays in Persuasion (1933), he discusses the impact of the automatic stabilisers on tax receipts and spending."

     "He writes that “We have reached a point where a considerable proportion of every further decline in the national income is visited on the Exchequer through the agency of the dole and the decline in the yield of the taxes. it is natural, therefore, that the benefit of measures to increase the national income should largely accrue to the Exchequer”.

    "He then wrote:

If we apply this reasoning to the projects for loan-expenditure which are receiving support today in responsible quarters, we see that it is a complete mistake to believe that there is a dilemma between schemes for increasing employment and schemes for balancing the Budget, – that we must go slowly and cautiously with the former for fear of injuring the latter. Quite the contrary. There is no possibility of balancing the Budget except by increasing the national income, which is much the same thing as increasing employment.

     "So he thought austerity was bad if the government wanted to “balance the budget” but that fiscal stimulus would not undermine that aim."

   "So there is some truth in Paul Krugman’s notion that being “Keynesian” meant that you advocated temporary fiscal deficits."

    "That, of-course, sets his position apart from the Functional Finance principles developed by Abba Lerner which Modern Monetary Theory (MMT) is more closely aligned with."

    "Functional finance says that government should always be guided in its policy choices by how effective they in influencing national income and employment."

    So Mitchell's difference here is I guess that Keynes didn't absolutely rule out balancing the budget-he was fairly agnostic-but did argue against the use of austerity to get you to a BB. 

    What he said would hold up in the Post War period when America had a huge debt to GDP number that sunk naturally without any austerity at all. 

     Krugman  believes that you should have a decfict during recessions but that you should if not balance the budget at least bring down the deficit during booms. No question the position of permanent fiscal stimulus on the part of MMT is a revolutionary one. 

  P.S. During recessions Keynes, Krugman, and MMTers basically agree-austerity is counterproductive. 

     During booms is the difference. Both Keynes and Krugman likely will agree to bigger government but not that this is stimulative during booms. Krugman would argue that the deficit should be brought down. Keynes would at least say that austerity is not the way to achieve a higher level of budget balance.