December 2011

Much debate about economic policy today can be described as taking place between Keynesians and anti-Keynesians.

The latter is made up of an uneasy coalition of Austrians and Chicago-inspired monetarists. The former looks to John Maynard Keynes, who, in his landmark book The General Theory of Employment, Interest, and Money, argued that developed economies were prone to “liquidity traps” — in which monetary policy becomes exhausted, and governments must resort to deficit spending to stimulate the economy.

Given such a drastic diagnosis and prescription, a close examination of Keynes’ own writings is clearly in order. Can Keynesian liquidity traps happen? Keynes himself admitted he had never seen one, although his model predicted them. Well, we might ask, is his model plausible? And does it describe the Great Recession? And if so, will deficit spending help?

Making the case against these claims is this month’s lead essayist, Tim Congdon, often described as the United Kingdom’s leading monetarist. In a close reading of The General Theory, Congdon finds that many of the simplifying assumptions that Keynes made in presenting his model are in fact fatal to the model itself. Moreover, Keynes’ later followers, notably Paul Krugman, are describing a very different phenomenon when they talk about being in a liquidity trap.

These are serious claims with far-reaching implications. To discuss them, we have invited three other notable economists, each of whom will respond to Congdon during the course of the month. They are Dean Baker, co-director of the Center for Economic and Policy Research; Don Boudreaux of George Mason University; and Robert Hetzel, an economist with the Federal Reserve Bank of Richmond.


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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.

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