Back to the Old Grind

I've been taking a bit of a break from full-scale Krugman confrontation lately. What he writes here, in his "wonkish" way, is basically more of the same, but I thought I would extract this bit and comment on it:

Early on in this crisis I and quite a few other economists — but not enough! — declared that we had entered a classic liquidity trap. This is a situation in which even a zero short-term interest rate isn’t low enough to restore full employment; it is, if you think through the logic, a situation in which desired saving, or more accurately the savings people would make if we were at full employment, exceed desired investment even at a zero interest rate.

The liquidity trap — which is in effect a special case of IS-LM analysis — has some special properties. Notably, even large government borrowing won’t drive up interest rates (not unless the borrowing is enough to restore full employment), and you can print as much money as you like without causing inflation.

1. This is not a "classic" liquidity trap. As I discuss at length here, in a classic liquidity trap the central bank is essentially trying to accomplish something by swapping currency for government debt, and those two assets are essentially the same. The nature of the liquidity trap we are now in is that a swap of interest bearing reserves for T-bills accomplishes nothing, because those two assets are the same, and that would be true whether the interest rate on reserves were 0.25%, 5%, or 20%. What gives rise to the modern-day liquidity trap is that there is a large positive stock of excess reserves in the financial system. Further, this liquidity trap is even more damning, as quantitative easing will not accomplish anything either - swaps of short-term debt for long-term debt simply get undone by the private sector.

2. Make government borrowing large enough, and interest rates will go up alright, liquidity trap, no liquidity trip, "full employment" (whatever Krugman thinks that means) or no full employment. We understand what that is all about. Make the government debt large enough, and it's unsustainable.

3. You can't "print as much money as you want without causing inflation." In spite of the fact that, in our modern-day liquidity trap, swapping reserves for government debt does not matter, the fact that the reserves are out there can matter for future inflation, but that depends on future central bank actions. If something happens to make the banks less willing to hold the reserves, the Fed can increase the interest rate on reserves so that the banks want to hold the reserves, with no resulting inflation. If Krugman means to say that the banks are going to hold the reserves indefinitely at 0.25%, then that's not right.

4. To say that IS/LM - a model with no dynamics, two assets ("money" and "bonds"), no credit, no default - is going to enlighten us, in the way Krugman thinks it does, about "how the world works," is a pretty bold statement, to say the least. More on that here.

Krugman finishes up with:

The moral of the story, then, is that one view of macroeconomics has held up very well in the Lesser Depression; the alternatives have been shown wrong again and again.

How are we supposed to evaluate that? IS/LM seems a complete non-starter. How can you say it "holds up?" What are the alternatives that he wants to compare this to anyway? Are those alternatives something anyone even thinks about? As usual, you know the answers. The alternatives are straw men that exist only in Krugman's mind.