Liquidity Traps and Keynesian Confusion

One of the ideas held dear to Keynesians is the Liquidity Trap. Due to a number of factors, demand for money may be greater than demand for goods, which results in hoarding, reduced spending, and a stagnant economy. The solution, according to the Keynesians, is to create inflationary expectations and reduce the nominal interest rate to near zero, thus stimulating spending and discouraging saving. That's the theory anyway.

The problem with this idea is that an increase in the demand for money is just a decrease in demand for the goods being produced in the economy. If an economy is geared towards producing things that are not desired by consumers, spending will fall and people will increase their liquidity reserves. In the absence of Keynesian low (or zero) interest rate responses, the unprofitable investments will be liquidated. This allows investment in the things that consumers actually want, whatever that happens to be at the time. In other words, without the Keynesian monetary intervention, the economy will slide a bit for a little while as it gets itself back on track for growth.

When the Keynesian monetary policy is in effect, however, unprofitable investments are not liquidated. If I have a zero percent interest loan on a mud factory that I own (that is, capital dedicated to something that people don't want) then I can stay open for a long, long time without making very much money. The needed readjustments take much longer, if they happen at all. What would have been a short term recession is turned into a longer-lasting economic slump by the very policies that are intended to avert the recession.

What the Keynesians don't understand is that sometimes, a short recession is needed in order to liquidate bad investments. The timing of this recession is easy, since reduced consumer spending is both the means of signaling bad investments and the trigger for the recession. If central bankers could control themselves instead of always pursuing an active monetary policy that props up bad investments, we would all be much better off.

Your right that short recessions are needed to liquidate bad investments and most keynesians would agree this too.

The problem is that your asuming keynesians are over eager to reduce interest rates. i.e. any dip in growth must be counter acted by interest rate movements. Your taking keynesian ideas to the extreme.

If the economy is experiencing a sustained downturn in growth then keynesians would argue a small decrease in interest rates. This decrease would mainly increase the spending power of consumers (from reduced interest payments), this would fuel successful companies to expand production etc....

The marginal dip in interest rates is unlikely to cause an occurance of bad investments, although it might convince the more risk adverse entrepreneur to take out a loan, its foolish to imply a large number of bad investments would occur.

And dont forget, the banks still have to accept or reject business proposals. They are a business too and they want to avoid bad investments.

I've yet to meet a Keynesian who suggested that recessions are a necessary part of a healthy economy. Maybe I've just been really unlucky and only met the fanatics on jihad against the business cycle while the majority see that it is necessary and beneficial, but I don't think that's very likely.

Look at Japan and tell me they aren't doing exactly what I described. And yes, Keynesians are over-eager to reduce interest rates. That's been their legacy since Maynard was around.

The very best interest rate policy anyone could hope for is to somehow match the rates individual banks would be setting themselves in the absence of a central bank dictating policy and ensuring them against failure. Unfortunately cental banks have no idea what that rate would be, since it is a matter of consumer time-preferences and neither central banks nor anybody else knows what those preferences would be without a market system to allow for consumer feedback. So, instead of having individual banks setting rates to maximize profits at a market clearing level and adjusting their rates in response to supply and demand for credit (which, coincidentally, would mean higher rates when things are growing a lot and lower rates when things slow down) we get a central bank that's essentially guessing, with no accountability whatsoever and no way of knowing if their guess is right until far into the future. What a great system.

No, it's not foolish. People push capital towards its best use first, according to their judgement. As more credit becomes available, more marginal investments that just weren't quite good enough before now appear profitable. It is undeniable that the an expansion of credit leads to more investments that are seen to be less profitable, or more risky, than the investments that were made previously.

A "bad" investment is one that gives economic losses, or in other words real losses or profits that are less than opportunity cost. As more credit becomes available through the central bank, the standard by which an investment is judged is lowered. For example, imagine there is an investment that offers a 3% rate of return in a zero-inflation environment. If the interest rate is 1%, that is a profitable investment. If the interest rate is 5%, that is a bad investment. If a zero-point interest rate policy is in place in an inflationary environment (remember, Keynesian policy for escaping a liquidity trap) banks will throw money and credit cards at practically anybody.

About banks avoiding bad investments, there is less of an incentive to do this when a bank knows that they will be bailed out if they fail. This leads them to dump money into high-risk and high-yeild investments that they wouldn't dream of making if they were actually exposed to the full risk of these investments.

Except for all those monetarists around, advocating a slow and constant growth of the money supply rather than an active monetary policy.

Little help that is. Active monetary policy is fumbling around in the dark. Keynesians, as a rule, advocate active monetary policy and central bank attempts to manage the business cycle. It's a qualitative difference here, not a quantitative one, so calling them "moderate" doesn't mean a whole lot.

Heh. I'd like to see your definition of what "moderate Keynesianism" entails. Maybe a "moderate" belief in the Phillips Curve? Maybe a "moderate" belief in active monetary policy? Sure.

You could say that, but you'd be wrong.

Moderate philips curve = A curve which shifts in the long run yet has short term properties of an inflationunemployment trade off, DER!

Moderate monetary policy = Fixed rule not discretionary, easy, easy, easy!

That looks like a grab for intellectual territory, claiming ideas for Keynes which simply were not his.

And the difference is? Writing your heuristic down makes it moderate? I don't buy it.