Thursday, February 2, 2012

Not What Keynes Had in Mind

Keynes didn't consider the concept of liquidity trap to be too relevant in practice. He knew that, in the case of near-zero interest rates, the speculative demand for money would be infinite, the demand for bonds would be null, and borrowing would increase, so interest rates would probably rise and take the economy out of the trap (a good summary of this point is provided in Handa's Monetary Economics).

And this is exactly what happened during the early stages of the current financial crisis. People who believe that the US found itself in a liquidity trap should at least acknowledge that this was the artificial creation of a central bank subservient to a prodigal treasury operating in a financially repressed economy.

Keynes was worried about the hypothetical lack of autonomous demand and how "benign" government debt could be used to compensate for it. Chronic overindebtedness, financial deleveraging and repression, and a central bank that enjoys the role of quasi-fiscal authority were not among his most well-known theoretical concerns.

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