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Wednesday, June 2, 2010

Liquidity Trap or Malinvested Resources?

Keynes versus the Austrians.

Many people claim today that the U.S. economy is in a “liquidity trap” and only government can spend us out of this mess. Commentators from Paul Krugman to Martin Wolf of the Financial Times assert we are in a “Keynesian situation”; unless government spending rescues us, we are doomed to suffer decades of economic stagnation.

The idea is simple, and appealing. According to those who follow Keynesian analysis, when the economy slows, due to less aggregate spending by consumers, there are two ways to “stimulate” it to “full employment.” The first is for the central bank to lower interest rates to encourage business borrowing and thus more spending.

However, what if interest rates are near zero already and businesses still are not borrowing? In that situation Keynesians claim that individuals and businesses prefer to hold cash because they anticipate that interest rates may rise in the future. When that happens, the second policy prescription should be employed: increased government borrowing and spending to directly increase aggregate demand.

“Monetary policy” and “fiscal policy,” as they are called in economics textbooks, are simple and very popular. First, they are quite easy to teach: Instructors simply convert the typical supply-and-demand diagram into an “aggregate supply-aggregate demand” model. Instead of prices and quantity on the vertical and horizontal axes, respectively, the vertical axis on the AS-AD gives the “price level” and the horizontal axis denotes “Y,” or gross domestic product (GDP).

The trick to putting the economy into “full employment” of resources is to move AD to the point where the economy nears “capacity.” But an economy caught in a “liquidity trap” is not going to see AD shifted by “monetary policy,” or the lowering of interest rates. Thus the only way for the economy to be “rescued” from this “equilibrium” of low output and high unemployment is for governments to borrow and spend, even at what might be considered to be “reckless” levels. Martin Wolf writes:

If, alternatively, monetary policy is ineffective, as it may be, fiscal tightening should be announced, but implementation should be postponed until recovery is secure. I have now lost faith in the view that giving the markets what we think they may want in future – even though they show little sign of insisting on it now – should be the ruling idea in policy. [Emphasis mine.]

Another Explanation

Economists of the Austrian school give another explanation, which resorts to neither Keynesian policy prescription and in which there is no such thing as a “liquidity trap.” Last week I wrote of malinvestments, which are investments made during the a boom that cannot be sustained because consumer spending patterns, which ultimately determine production structures within the economy, will not permit investments at their previous levels. (The collapse of the housing boom created the present situation.)

Austrians note that government actually retards economic recovery by holding down interest rates. First, government tends to target new money created by the banking system toward those industries that have become depressed, ignoring the malinvestments that originally put them into that situation. Thus malinvestment persists, pulling capital and resources from economic sectors that originally were not as badly damaged during the boom and subsequent recession.

Second, economist Robert Higgs notes that government activism to end the downturn creates what he calls “regime uncertainty.” In its efforts to “do something,” Higgs notes that governments often are hostile to private property rights and discourage long-term investments by healthy firms. Furthermore government is even more hostile to profitable firms and successful individuals, claiming they are not “paying their fair share” of taxes, making future investment less certain.

The U.S. economy recovered nicely from a severe recession in the 1980s, even with double-digit interest rates and low rates of inflation, which Keynesians would claim to be impossible. True, government spending rose during that time, but not nearly at the rate it has risen the past few years.

There was no “Keynesian situation” then, and there is none today. There only are malinvestments.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.