Bubbles, Liqiudity Trap

Canadian Public Policy

Monetary Policy after Bubbles Burst: The Zero Lower Bound, the Liquidity Trap and theCredit DeadlockAuthor(s): David LaidlerReviewed work(s):Source: Canadian Public Policy / Analyse de Politiques, Vol. 30, No. 3 (Sep., 2004), pp. 333-340Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3552306 .Accessed: 24/01/2012 10:22

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Issues and Commentaries

Issues et commentaires

Monetary Policy after Bubbles Burst:

The Zero Lower Bound, the

Liquidity Trap and the Credit

Deadlock

DAVID LAIDLER

University of Western Ontario London, Ontario and C.D. Howe Institute

L'usage aujourd'hui rdpandu de modules de politique mondtaire liant les ddpenses aux taux d'intdret, en ndgligeant de prendre en compte l'interaction de l'offre et de la demande d'argent dans le m6canisme de transmission, laisse dans l'ombre plusieurs importantes questions de politique et commence a engendrer une <<perte de m6moire> professionnelle dans certains de ces domaines. L'illustration de cette assertion se trouve dans les r6centes dicussions

portant sur la gestion de la politique mon6taire dans le sillage des crises financieres, en particulier lorsque les taux d'int6ret a court terme sont proches de zero, ainsi que cela s'est produit recemment au Japon.

The current widespread use of models of monetary policy that link expenditure to interest rates, while by-passing interaction of the supply and demand for money in the transmission mechanism, fails to illuminate several important policy issues, and is beginning to create a professional "memory loss" in some of these areas. This claim is illustrated with reference to recent discussions of the conduct of monetary policy in the wake of financial crises, particularly when short interest rates are close to zero, as they have recently been in Japan.

Revised version of an address delivered on Saturday, 5 June 2004 at the Purvis Luncheon during the Annual Meeting of the Canadian Economics Association/Association d'Economie Canadienne, held at Ryerson University, Toronto, Ontario. The author, who thanks Claudiu Tunea for help in its preparation, is Bank of Montreal Professor Emeritus at the University of Western Ontario and Fellow in Residence at the C.D. Howe Institute.

CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 3 2004

334 David Laidler

THE PURVIS PRINCIPLE

About 15 years ago, probably in a beer tent at a CEA meeting, Doug Purvis proposed a rule for

monetary policy which, he suggested, would simul-

taneously satisfy the Bank of Canada and those who

supported its efforts to bring the inflation rate down, as well as those who were pointing with trepidation to the likely imminent effects of high nominal interest rates on real income and employment, not to mention corporate profits. That rule, which I have ever since thought of as the Purvis Principle, was: "sound money, and plenty of it!"'

Doug could always be relied on to bring good humour and good economics to bear in equal measure on policy issues, and both were sorely needed 15 years ago. It is hard to remember nowadays that in 1990

many adults could not recall when the federal budget had last been in balance or when the inflation rate had last been below 5 percent, and that about the only thing our profession could agree on was that monetary policy was heading into uncharted territory. Debates then were carried on with an intensity that has no parallels in current discussions of, shall we say, the choice between

raising the overnight rate by 25 basis points at the next

meeting or waiting till the following one, or of relying more on economic growth and less on budget surpluses further to reduce the public debt-to-GDP ratio.

The performance of the Canadian economy has also

greatly improved since 1990, though this did not happen as quickly as many of us had then hoped. But in this talk, I want to draw attention to something else that has changed in recent years, though not altogether for the better, namely the standard analytic framework which the majority of economists, not just in Canada but in advanced economies in general, use when they discuss monetary policy problems.

THE NEW THEORY OF MONETARY POLICY

To begin with a little pedantry: the humour inherent in the Purvis Principle derives from the simultane-

ous attachment to the noun "money" of the qualifi- ers "sound" and "plenty of." Everyone familiar with the quantity theory of money knows that there is, shall we say, a certain tension here, and 15 years ago that theory in one or other of its many variants was our workhorse when we discussed inflation.2 Even though central banks had always used an interest rate as their principal policy instrument, and even though money-growth targeting had foundered on instability in demand for money functions in the

early 1980s, most economists still thought of mon-

etary policy's transmission mechanism as ultimately being a matter of the interaction of the supply and demand for money. The interaction in question had turned out to be more complicated than had once been hoped, so something more than a constant rate of monetary expansion was needed to bring about a desirable inflation outcome, but that interaction was still of central importance. This was so much taken for granted that, 15 years ago, the Purvis Principle was a very good joke that everyone got.

The outcome of work on the transmission mechanism since then, however, has been a new analytic workhorse from which the quantity of money has

virtually disappeared. Monetary policy is nowadays executed by practitioners, and analyzed by economic theorists, using a recursive framework in which:

(i) an interest rate under the control of the central bank affects aggregate demand; (ii) aggregate demand relative to the sustainable level of aggregate supply influences an "output gap"; (iii) the output gap causes inflation to vary relative to expectations; and (iv) the central bank adjusts its interest rate ac-

cording to a "Taylor rule" that links it to the behaviour of inflation relative to target, and perhaps to the output gap too. Within that general framework, there is ample room for debate and research

concerning, for example, the time lags in the system and their implications for its stability, the determination of the sustainable level of aggregate supply, the formation of inflation expectations, etc.

This general framework has therefore come to define a self-contained research agenda in the theory


Monetary Policy after Bubbles Burst 335

and practice of monetary policy. Its literature is

large, widely read, rapidly growing, but maturing too, and has recently received a definitive exposi- tion in Michael Woodford's important book Interest and Prices (2003). And yet this new agenda is pay- ing less and less attention to the role that money plays in coordinating agents' activities in a market

economy, of the implications of this for agents' demand for money, and of the mechanism whereby the Central Bank interacts with the banking system to cause the supply of money to vary. Its development is thus separating the theory of monetary policy from traditional theories of money, and from much of the

history of monetary economics too, because this sepa- ration is almost without precedent.3

The new agenda is undoubtedly helpful to

inflation-targeting central banks, and has produced operating procedures that work much better than

anything based on money-growth targeting, but its usefulness comes at the cost of leaving out a considerable amount that academic commentators on

monetary policy might want to discuss. Considered in isolation, it tells us a great deal about how to control inflation, but next to nothing about why we should bother; and, among other things, it is silent on the role that the monetization of government debt can and often has played in generating inflation, and it seems to have little to say about the international

monetary system.

So long as this new agenda remains as it now is, merely a part of the broader discourse of monetary economics, not much harm will be done, but to the extent that we begin to treat it as a self-contained and sufficient approach to the analysis of monetary issues and it comes to dominate research in the area, it will become dangerous. Were economics ever to forget what it nowadays knows about the above- mentioned topics, it would be sadly diminished, but, as any historian of economic thought knows, good ideas that are commonplace in one era do sometimes get mislaid as new research agendas replace old ones, so there should be no complacency here. In- deed, I shall now argue that serious memory losses

are already occurring under the influence of the new agenda.

Specifically, I shall suggest that, to judge from much that has been written on the topic of Japanese monetary policy over the last decade, the new agenda has already caused the discipline to lose track of a great deal of what it once knew about how to cope with the monetary problems that follow the burst-

ing of speculative bubbles. I shall also suggest that this forgetfulness is an early warning sign that there are other losses to come if the modern theory of monetary policy does not soon re-establish its links with the theory of money.

BURST BUBBLES AND THE ZERO LOWER BOUND

Situations such as prevailed in Japan in the 1990s are a rarity, but there have been precedents, notori- ously the US experience of the early 1930s, whilst lesser "bubbles" occurred elsewhere at the beginning of the 1990s. Some would even argue that the US came close to providing a further example at the very end of the same decade. In each case, and with benefit of hindsight, the trouble involved in- tense speculative activity in financial markets, its sudden cessation and then collapse, this being followed by at least chronic weakness, and at worst serious failures, in the financial sector. These fluctua- tions in the financial sector were associated with rapid expansion and then collapses in particular sectors of the real economy too - real estate in Japan and elsewhere at the beginning of the 1990s, real estate and consumer durables in the late 1920s US, high-tech equipment at the end of the 1990s, and so on.

This is not the place to argue about the causes of bubbles and their collapse. Whether they are pre- cipitated by monetary policy errors, a lack of appropriate regulation in the financial sector, or re- flect some tendency to instability residing deep in the growth processes of capitalist economies will always be a matter for debate. It is simply a fact


336 David Laidler

that, after they have burst, they are usually followed

by a period of depressed real economic activity and sometimes, crucial to the current discussion, of very low nominal interest rates that approach zero at the short end of the spectrum, as well as by a tendency of the general price level to fall. When viewed

through the prism of the new theory of monetary policy, these after-effects present an awkward problem: namely, though the arithmetic of the Taylor rule would call for further cuts to interest rates in such circumstances, the institutional fact that these have a lower bound of zero prevents this being done. Hence, according to the new agenda, orthodox mon-

etary policy is rendered helpless, and special measures are needed.

This latter theme has dominated commentary on

Japan in the 1990s and, recalling the once prevail- ing conventional wisdom about the 1930s in the US, this commentary has declared that economy to be in a liquidity trap. Its principal findings have, for

example, recently been summarized by Lars Svensson in a paper entitled "Escaping from the

Liquidity Trap and Deflation: The Foolproof Way and Others" (2003). That I focus some of the discussion that follows on this particular contribution, should be taken as a compliment to its exemplary clarity and comprehensiveness, rather than a criti- cism of any special weaknesses, for the problems this paper presents are quite general to the literature that it surveys.4

In a nutshell, Svensson's argument is that, in Ja-

pan short interest rates can fall no further, and that base money and treasury bills have become perfect substitutes so that there is no relief to be had from

increasing the quantity of the former. The way out is (i) to induce immediate expectations of inflation that will lower the expected own real rate of return on money; this to be accomplished by rendering credible a rising target for the domestic price level with the assistance of currency depreciation within a crawling peg regime, and (ii) to put in place an exit strategy involving abandoning the crawling

exchange rate peg in favour of domestic price-level or inflation targeting alone. And Svensson recommends this policy not just for contemporary Japan, but for

any open economy caught in a similar situation.

The first question that arises when one tries to restate Svensson's analysis in terms of the interaction of the supply and demand for money, and recalls some of the literature that treated the US experience of the 1930s in these terms, is why the existence of an

essentially zero nominal interest rate on treasury bills should be taken as prima facie evidence of the existence of a liquidity trap, and hence of the impotence of

monetary policy. Svensson's only reference to this earlier literature is his comment that "Keynes used the term 'liquidity trap' but there is considerable uncer-

tainty about what he meant" (Sumner 2002 quoted in Svensson 2003, 147). Scott Sumner is usually more reliable than he seems to have been on this occasion, but Svensson was unwise to rely on a secondary source, because in this case, he is wrong on both counts.

THE LIQUIDITY TRAP AND THE CREDIT

DEADLOCK

Contrary to Svensson (or Sumner), Sir Dennis

Robertson, not Keynes, used the term "liquidity trap." Nevertheless, in The General Theory of Em-

ployment, Interest and Money Keynes was quite clear what was involved in liquidity preference be-

coming absolute. His ambivalence concerned the

empirical relevance of the phenomenon. Thus, he told his readers that

The short-term rate of interest is easily control- led by the monetary authority ... But the

long-term rate may be more recalcitrant when once it has fallen to a level which, on the basis of

past experience and present expectations of future monetary policy, is considered unsafe by representa- tive opinion (1936, 203, italics in original).

A little later, he elaborated as follows:



There is the possibility ... that, after the rate of interest has fallen to a certain level, liquidity- preference may become virtually absolute in the sense that almost everyone prefers cash to hold-

ing a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in the future, I know of no example of it hitherto (ibid., 207).

On the same page, he retreated a little:

The most striking examples of a complete break- down of stability in the rate of interest, due to the liquidity function flattening out in one direc- tion or the other, have occurred in very abnormal circumstances ... in the United States at certain dates in 1932 there was a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms (ibid.).

And later in the book, he retreated even further:

in certain circumstances such as will often oc- cur, these [characteristics of money] will cause the rate of interest to be insensitive, particularly below a certain figure, even to a substantial increase in the quantity of money in proportion to other forms of wealth (ibid., 233).

In short, there can be no question that, though he was ambivalent about the empirical relevance of the

phenomenon that Robertson called the liquidity trap, Keynes was quite clear that it involved the demand for money becoming essentially infinitely elastic with respect to the long rate of interest failing to fall in the face of a substantial increase in the money supply relative to wealth in general.

So, to return to Japanese experience: first a short rate of interest in the vicinity of zero has little to do with the case; and second, to demonstrate the exist-

ence of a liquidity trap in that economy one would have to point first of all to evidence of a substantial increase in the quantity of money, somehow measured. Before the Bank of Japan's policy of "quantitative easing" was implemented in early 2001, however, there was no such evidence. The ratio of the mon-

etary base to nominal GDP rose from a little under 10 percent at the beginning of 1991 to a little over 14 percent at the beginning of 2001, but since then has jumped to about 21 percent; and the ratio of Ml to nominal GDP rose from about 45 percent at the

beginning of 2001 to over 70 percent at the beginning of 2004. Japan might have been in a liquidity trap in the 1990s, and indeed Paul Krugman declared that it was as early as 1998, but the experiment that could generate evidence to support this contention was not implemented until 2001.5

It is too early to pass a confident judgement on the issue, but given that Japan's real GDP began to

expand in the first half of 2002, and that its growth rate has now reached about 5 percent per annum, nearly all driven by domestic demand, it is surely beginning to look extremely unlikely that the liquidity trap was ever important in that economy.

Short-term interest rates were nevertheless almost zero in Japan during the 1990s, and the price level did begin to fall, so, when viewed in the light of the new theory of monetary policy, such a situation does indeed seem to present a problem for a central bank. This, however, is not the first time that such conditions have developed, nor the first time that a central bank has been declared helpless in face of them by the majority of economists. Keynes's conjecture that there might have existed a liquidity trap in the US at certain times in 1932 reminds us that this issue has been addressed before. It should also remind us that well before 1936 there already existed another

diagnosis of the US situation that led to an altogether more optimistic view about the powers of monetary policy to deal with it. Like the liquidity trap, that diagnosis also came equipped with a colourful la- bel: it was called a credit deadlock, and its initial


338 David Laidler

development was the work of Ralph Hawtrey. As with Keynes on the liquidity trap, we may let

Hawtrey speak for himself on the credit deadlock. In 1931, he pointed out that

a moderate trade depression can be cured by cheap money. The cure will be prompter if a low Bank Rate is reinforced by purchases of securities in the open market by the Central Bank. But so long as the depression is moderate, low rates will of themselves suffice to stimulate borrowing.

On the other hand, if the depression is very se-

vere, enterprise will be killed.... In that case the

purchase of securities by the Central Bank ... becomes an essential condition of the revival be-

ginning at all. By buying securities the Central Bank creates money, which appears in the form of deposits credited to the banks whose custom- ers have sold the securities. The banks can thus be flooded with idle money, and given a new and

powerful inducement to find additional borrowers (1931, 30-31).

By 1932, he stated the same position even more

pointedly.

It may happen that demand is so contracted and markets are so unfavourable that traders, seeing no prospect of profit, abstain from enterprise and do not borrow. The reluctance of borrowers may cause a contraction of credit quite as effectively as the reluctance of lenders.

When that happens it seems to be the extreme of

paradox to say that there is a shortage of money ...

But the low rates are merely the outward expres- sion of the unprofitableness of business and the unwillingness of traders to borrow ... There is a deadlock which can best be broken by injecting money into the system.

Now the central bank has the power of creating money (Hawtrey 1932, 172).

And then, having once again described how open market operations would come into the picture, Hawtrey concluded that

there must ultimately be a limit to the amount of

money that the sellers will hold idle, and it follows that by this process the vicious circle of deflation can always be broken, however great the stagnation of business and the reluctance of borrowers may be (ibid., 174).

These passages from Hawtrey's work date from the beginning of what Friedman and Schwartz

(1963) would subsequently call the Great Contrac- tion, but their message can also be found, albeit stated with less urgency, in his earlier writings. In the early 1930s, that message was soon developed by others, notably Lauchlin Currie (1934a, b), his sometime assistant at Harvard. Versions of it under-

pinned the writings of a number of others too, notably those pioneers of the "Chicago Tradition" from whom Milton Friedman later drew inspiration; and Friedman and Schwartz's (1963) diagnosis of the failure of Federal Reserve policy in the 1930s, recently reaffirmed and elaborated by Allan Meltzer

(2003), clearly has much in common with Hawtrey's original analysis.

Experience in Japan since 2001 is beginning to

suggest that this analysis retains considerable relevance for the modern world as well. The Bank of

Japan's policy of quantitative easing has demon- strated beyond any reasonable doubt that a modern central bank can indeed bring about a significant increase in the monetary base and in the supply of narrow money by way of open market operations, even when short interest rates have reached zero and

prices are falling, and the subsequent behaviour of

output is consistent with the hypothesis that the

Japanese economy was, after all, suffering from a credit deadlock in the 1990s.

And yet what I have called the new theory of monetary policy cannot accommodate this way of looking at things. It bypasses the interaction of the



supply and demand for money in its account of the transmission mechanism, and hence does not help its advocates to distinguish between, on the one hand, a demand for money function that is highly elastic with respect to the long rate of interest and, on the other, a demand for bank-loans function that is highly inelastic with respect to the short rate. Furthermore, it blinds them to the possibility that

money might be substitutable on margins other than the one defined by treasury bills, and that there are

good reasons to believe that a gap between its own rate of return and that on real goods, particularly durable goods, can be opened up by the simple ex-

pedient of increasing its quantity, rather than by elaborate schemes to induce expectations of higher future inflation by way of manipulating the exchange rate.6

THE PURVIS PRINCIPLE VINDICATED AND OTHER CONCLUSIONS

Surely Doug Purvis would have appreciated the

irony implicit in the foregoing conclusion, because it implies that, under the extreme conditions that follow the bursting of a bubble, his "sound money and plenty of it" policy principle ceases to be a joke, but becomes highly relevant. But the professional memory losses that the modern theory of monetary policy has already brought about are no laughing matter either. Immersion in that agenda seems to have led an influential group of economists, intellectual leaders in the field, to display an uncertain

grasp of Keynes's theory of what came to be called the liquidity trap, to forget Hawtrey's theory of the credit deadlock (if they were ever aware of it), and even more striking, to neglect the implications for current policy of the historical work done on the United States of the 1930s by Friedman and Schwartz (1963) and Meltzer (2003).7

These losses need to be halted, and indeed re- versed, without delay, before we also forget why controlling inflation matters, why budget deficits can have inflationary consequences, and why the inter-

national monetary system requires the attention of

policymakers, not least in the United States whose

currency is the principal unit of account, store of value, and means of exchange within that system. That can easily be done if, first, we treat our new

agenda for the study of monetary policy for what it

really is; namely, an extremely useful framework for guiding and improving the practical conduct of

monetary policy in the rather stable monetary envi- ronment of an economy where low inflation is being successfully targeted, and not as a general theory of

policy in a monetary economy; and second, we treat the exploration of the intellectual links between that

agenda and our inherited theory of money as a serious and worthwhile enterprise.

NOTES

'I can vouch personally for this piece of "oral tradition." I don't think that Doug ever committed this saying to print, but, if he did, I would be delighted to learn of it.

2The reader is reminded that, even in the most orthodox "Keynesian" IS-LM system prices rise in proportion to the quantity of money at full employment. I refer to "many variants" of the quantity theory above in order to include models like this. Finer distinctions would obviously be in order were the topic of this talk the history of inflation theory in the second half of the twentieth century.

31 am using "theories of money" to encompass quite a broad range of ideas here, for there are obviously many variants within the overall picture. I set out my own pre- ferred version in my presidential address to this association in Laidler (1988).

4Svensson's bibliography contains 52 items, includ- ing data sources. Of these, no fewer that 17 refer to the liquidity trap, the yen trap or the zero lower bound in their titles.

5Readers who wish to see more detail are referred to Bank of Japan (2004) Charts 41 and 42 for relevant monetary data, and Chart 2 for real GDP growth.

6Money's substitutability across a wide range of as- sets, real as well as financial, not to mention the role of the market for bank credit in the money supply process, were themes much stressed during the monetarist controversy,


340 David Laidler

particularly by Karl Brunner and Allan Meltzer, who gave a

retrospective account of their contribution in 1993.

7Svensson cites Meltzer in support of the contention that "there is broad agreement that monetary factors and mistakes by the Federal Reserve played a crucial role both in the onset and prolongation of the Great Depression" (2003, 148), but does not examine the possibility that this statement might raise questions about his treatment of recent Japanese problems.

REFERENCES

Bank of Japan. 2004. Monthly Report of Recent Economic and Financial Developments (June).

Brunner, K. and A.H. Meltzer. 1993. Money and the

Economy. Issues in Monetary Analysis. Cambridge, UK: Cambridge University Press for the Raffaele Mattioli Foundation.

Currie, L. 1934a. "The Failure of Monetary Policy to Pre- vent the Depression of 1929-32," Journal of Political

Economy 42 (April):145-77. 1934b. The Supply and Control of Money in the

United States. Cambridge MA: Harvard University Press.

Friedman, M. and A.J. Schwartz. 1963. A Monetary His-

tory of the United States 1867-1960. Princeton, NJ: Princeton University Press for the NBER.

Hawtrey, R.G. 1931. Trade Depression and the Way Out. London, New York, Toronto: Longmans, Green & Co.

1932. The Art of Central Banking. London:

Longman Group. Keynes, J.M. 1936. The General Theory of Employment,

Interest and Money. London: Macmillan.

Krugman, P. 1998. "Its Baaack! Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity 2:137-87.

Laidler, D. 1988. "Presidential Address: Taking Money Seriously," Canadian Journal of Economics 21(No- vember):687-713.

Meltzer, A.H. 2003. A History of the Federal Reserve, Volume 1. Chicago: University of Chicago Press.

Sumner, S. 2002. "Some Observations on the Return of the Liquidity Trap," Cato Journal 21(3):481-90.

Svensson, L.E.O. 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Jour- nal of Economic Perspectives 17(Fall): 145-66.

Woodford, M. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton and Oxford: Princeton University Press.


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Bubbles, Liqiudity Trap