Tim Congdon on Liquidity Traps vs. Portfolio Rebalancing

Tim Congdon takes up the 1960s/1970s monetarist/Keynesian debate over the efficacy of monetary policy in recession.[1] In recession, does the combination of low interest rates and high unemployment rates signal the impotence of monetary policy? If so, does the case for the potency of fiscal policy follow? As with all “journalistic” economics in which commentators impute causation from correlation in a “commonsense” way, the Keynesian affirmative responses to these questions could be correct, but their validity requires careful analysis within the framework of economics. Without a framework that allows one to address the issue of simultaneity between the two variables (the interest rate and the unemployment rate) and the nature of the original shock, the Keynesian responses lack substance.

In their discussion of the Great Depression, Friedman and Schwartz (1963, 300) noted the common belief that in the Depression monetary policy was impotent, as captured by the common expression about the inability to push on a string. They countered: “The contraction [Depression] is in fact a tragic testimonial to the importance of monetary forces.” Hetzel (2012) makes the case that the 2008–2009 recession offers another example in the spirit of the Friedman/Schwartz criticism.

To start, it is important to clear away the confusion surrounding the popular use of the term “liquidity trap” as a catchall phrase expressing the impotence of monetary policy. A liquidity trap is different from the zero-lower-bound problem, which expresses the fact that in a world of fiat money the nominal interest rate cannot fall below zero. The real interest rate (the nominal interest rate minus expected inflation) is the price that borrowers pay for transferring consumption from the future to the present. Alternatively, it is the price that lenders receive for deferring consumption from the present to the future. If individuals are sufficiently pessimistic about the future, the real interest rate could be negative. By itself, however, that fact is uninformative for policy without knowledge of the shock (monetary or real) that caused the pessimism.

The zero-lower-bound problem is different from a liquidity trap. The idea of a liquidity trap is that individuals will exchange assets with the central bank for money to an unlimited amount with no incentive to run down their increased money holdings through additional spending. As a result, the central bank loses its ability to influence the dollar expenditure of the public. Tim makes the monetarist argument that as long as the central bank buys illiquid assets, the public is left with a more liquid asset portfolio after the exchange. If the public was holding a balanced portfolio before, then it will try to run down its higher money holdings through bidding for other illiquid assets and, in the process, bid up their prices. Higher prices for illiquid assets like real estate and equities will make investment more attractive.

If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

What drives the conclusion that the central bank can control the dollar expenditure of the public is that the central bank can conduct monetary policy as a strategy, say, by altering the monetary base and the money stock by whatever amount necessary to maintain nominal expenditure on track. Historically, however, the FOMC has never been willing to communicate its behavior as a “policy” in the sense of systematic procedures designed to achieve an articulated, quantifiable objective (a reaction function). Instead, it communicates individual policy actions such as changes in the funds rate or, since December 2008, changes in the size and composition of its asset portfolio. Just as importantly, it explains those individual policy actions using the language of discretion.

The FOMC Minutes released after each meeting package the current policy action as optimal taken in the context of the contemporaneous state of the economy. As a matter of political economy, the FOMC can then attribute adverse outcomes to powerful real shocks originating in the private sector. In the event of inflation, as in the 1970s, it can blame the greed of powerful corporations. In the event of recession, as in the Great Depression and now with the Great Recession, it can blame the greed of bankers who made excessively risky, speculative bets. From this political-economy perspective, a “policy,” which requires a numerical objective, say, steady nominal expenditure, and an articulated strategy, say, a feedback rule running from a path for nominal expenditure to money creation, suffers two defects.

First, the explicitness of an objective communicates to the political system that the FOMC can take care of a problem that the FOMC considers to have been not of its making. A problem arising as a real shock should possess a solution coming from the political system, for example, through expansionary fiscal policy. Second, an explicit objective, by its nature, highlights misses. As a matter of accountability, however, that is the point. The FOMC must then explain rather than rationalize the miss by defending the miss as a real shock originating in the private sector rather than as arising from faulty policy based on a misunderstanding of the economy.

An alternative way of expressing Tim’s criticism of monetary policy in the Great Recession is to note the failure of central banks to maintain a steady rate of growth of nominal expenditure. In fact, central banks allowed nominal expenditure to decline in lock step with real expenditure. That behavior may have been appropriate. The appropriateness of the behavior depends upon the nature of the shock that pushed the economy into recession and that pushed the short-term interest rate to zero taken along with the nature of the failure of the price system that prevented it from offsetting the shock.

Central bank independence and accountability are indissolubly linked. The point made here, a point consistent with Tim’s criticism, is that accountability requires that the central bank move beyond the language of discretion, which historically has been the language of ex post rationalization, to the language of economics, which requires an explicit analytical framework linking numerical objectives to a strategy by the central bank for achieving those objectives. Within that framework and along with the debate that framework would permit with the economic profession, the central bank would have to evaluate its past behavior by comparing alternative possible shocks as the source of economic instability. Those shocks would include monetary shocks.


[1] The ideas expressed here are those of the author, not the Federal Reserve Bank of Richmond or the Federal Reserve System.


Hetzel, Robert L. The Great Recession: Market Failure or Policy Failure? Cambridge: Cambridge University Press, 2012.

Friedman, Milton & Anna Jacobson Schwartz. A Monetary History of the United States 1867-1960. Princeton: Princeton University Press, 1963.

Also from this issue

Lead Essay

  • Tim Congdon argues that John Maynard Keynes’ latter-day followers have badly misinterpreted the theorist they profess to follow. Led by Paul Krugman, Keynesians have claimed that a near-zero Federal Funds rate is indicative of a liquidity trap. This diagnosis has several problems. First, it is not what Keynes meant by the term; second, even a rate of zero percent does not exhaust monetary policy; and third, a genuine Keynesian liquidity trap has not happened and cannot plausibly happen, in part but not solely because Keynes assumed constant prices throughout the economy, a condition that is unlikely in the face of a rising money supply. Congdon commends to readers Milton Friedman’s monetary prescription: a gradually and predictably rising supply of money, not the wild swings we have seen in recent years.

Response Essays

  • Dean Baker argues that Keynesians have not given up on monetary policy. Although the federal funds rate can’t go negative, the Federal Reserve can still set a higher inflation target, a solution both he and Paul Krugman endorse. Alongside monetary policy, Baker recommends fiscal policy: The recent economic stimulus legislation worked as intended, he argues, although the recession was more severe than the administration anticipated, and thus the stimulus proved to be too small. Policymakers have a duty to try to return the country to full employment, as the unemployed, who are suffering the most in the current crisis, are not to blame for their troubles.

  • Don Boudreaux agrees with Congdon that a monetarist policy approach would be preferable, but he draws our attention to a third relevant consideration: regime uncertainty, as described by the economist Robert Higgs. When businesses are uncertain about the major economic decisions of governments and central banks, they will defer new investments and retain cash rather than hiring new workers. Neither monetarism nor Keynesianism does anything to address the problem, which Keynes himself conceded was real.

  • Robert Hetzel reiterates that a zero lower bound for interest rates is a different phenomenon from a liquidity trap. The latter is an “irrelevant academic construct” as long as the central bank can create new money. Still, we learn little from this distinction unless we can determine the nature of the initial shock that caused pessimism among market participants; different types of shocks, monetary and real, call for different remedies. Central banks rarely use the analytical tools that would be necessary for them to evaluate their own roles in economically rigorous ways; instead, they tend to blame difficult times on the private sector, while taking credit for good ones.