Global Crisis Blog

The Revenge of John Maynard Keynes:  Yes, Virginia, There IS a Liquidity Trap

By Shlomo Maital

 The theories of John Maynard Keynes, enunciated in his 1936 book The General Theory of Employment, Interest and Money, were fashionable for many years, and were used to guide practical policies.  Then they fell out of fashion, displaced by palpably ridiculous theories such as “rational expectations” (economic actors fully and accurately incorporate all economic data into their price expectations), theories that won proponents Nobel Prizes.  

    Well, friends, Keynes is back big-time.  For example, Keynes’ theory of the “liquidity trap” –the idea that monetary policy (credit expansion or interest rate reduction) can no longer stimulate economic activity, because interest rates may be at rock bottom or zero (they are today, in the U.S.) and because credit expansion has no palpable impact (banks absorb Fed-supplied liquidity, but do not pass it on, instead keep the money to shore up leaky balance sheets).  

    Federal Reserve Bank of Chicago President Charles Evans believes the U.S. is at present in a liquidity trap, as does Nobelist Paul Krugman and many other leading economists.  Yet Fed Chair Ben Bernanke continues to push a policy of QE – quantitative easing, buying bonds to pump more and more liquidity into the system. This angers China and Asia as a whole, which believes America is spilling too many dollars into the world markets and thus endangering Asian stability. 

    When monetary policy no longer works, why not try fiscal policy?  Great idea – except America is now working to reduce its budget deficits,  because the American people have come to believe (rightly) that much of the deficit spending was wasted on inappropriate ineffective bailouts of banks and financial institutions.   

    With the U.S. economy still very weak and with very little new job creation occurring, with monetary policy spent, and with fiscal policy no longer an option,  what are the options?  Don’t bother to ask the economists – they have no clue.

    The situation recalls Woody Allen’s joke about choosing between alternatives.  The world faces the choice between nuclear holocaust, or environmental catastrophe, he observed.

    May we choose wisely.