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<font color="#002864" size="1" face="Verdana">http://www.mises.org/fullstory.asp?control=1226</font>
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>The Liquidity-Trap Myth</strong></font>
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<font size="4">by Richard C. B. Johnsson</font>
<font size="2">[Posted May 19, 2003]</font>
<font size="2">![[image]]([/img] As<br />
concerns are raised about the risk of the Japanese economic malaise spreading<br />
to the U.S. and elsewhere, some commentators have tried to revitalize the old<br />
Keynesian idea of the"liquidity trap."</font><a title href="http://www.mises.org/fullstory.asp?control=1226#_edn2" name="_ednref2"><font size="2">[1]</font></a><font size="2"><br />
Although the trap itself follows from the J.R. Hicks IS-LM analysis, the basic<br />
idea is borrowed from J.M. Keynes.</font><a title href="http://www.mises.org/fullstory.asp?control=1226#_edn3" name="_ednref3"><font size="2">[2]</font></a><font size="2"><br />
In fact, Japan has not been in such a trap in the years following 1990. The<br />
whole idea of the trap is gravely flawed.</font><br />
<br />
<br />
<br />
<br />
<font size="2">According to Keynes, the relation between investment and <font color="black">Marginal<br />
Efficiency of Capital (MEC) is negative. Writes Keynes,"[t]o induce new<br />
investment 'the rate of return over cost must exceed the rate of interest',"<br />
referring to the words of Irving Fisher who"uses his 'rate of return<br />
over costs' in the same sense and for precisely the same purpose as I employ 'the<br />
marginal efficiency of capital'."<a title href="http://www.mises.org/fullstory.asp?control=1226#_edn4" name="_ednref4"><font color="black" size="2">[3]</font></a> </font></font><br />
<br />
<br />
<br />
<br />
<font color="black" size="2">Thus, as the difference between what is<br />
returned and the costs constitute the profits, Keynes was basically saying<br />
that to induce new investment, the rate of profit must exceed the interest<br />
rate. But as investment increases, any profitable investment opportunities are<br />
exhausted. This means that the rate of profit (MEC) falls and approaches the<br />
interest rate. And as it approaches the interest rate, businessmen will cease<br />
investing. This follows from Keynes's idea of the liquidity preference:</font><br />
<br />
<br />
<p dir="ltr" style="MARGIN-RIGHT: 0px"><font size="2">"The rate of<br />
interest at any time, being the reward for parting with liquidity, is a<br />
measure of the unwillingness of those who possess money to part with their<br />
liquid control over it. The rate of interest is not the"price"<br />
which brings into equilibrium the demand for resources to invest with the<br />
readiness to abstain from present consumption. It is the 'price' which<br />
equilibrates the desire to hold wealth in the form of cash with the available<br />
quantity of cash."</font><a title href="http://www.mises.org/fullstory.asp?control=1226#_edn5" name="_ednref5"><font size="2">[4]</font></a><br />
<br />
<br />
<br />
<br />
<font size="2">And because investors will be indifferent between holding<br />
cash and investing, investment collapses. According to these Keynesian ideas,<br />
if for some reason investment, output, and employment fall, there is a call<br />
for the government to intervene and lower the interest rate. Alternatively,<br />
the government could print money, since"[t]he expectation of a fall in<br />
the value of money stimulates investment."</font><a title href="http://www.mises.org/fullstory.asp?control=1226#_edn6" name="_ednref6"><font size="2">[5]</font></a><font size="2"><br />
Also, fiscal measures like tax cuts and public deficit spending could be<br />
recommended, where the latter is preferred because of a larger multiplier<br />
effect.</font><br />
<br />
<br />
<br />
<br />
<font size="2">The idea Keynes propounded was that the relation between<br />
profits<font color="black"> and investment was negative. Hicks, when<br />
creating the IS-LM framework, built on this idea. Within this framework, the<br />
IS-curve represents the negative relation between the rate of profit and<br />
investment that Keynes wrote about.<a title href="http://www.mises.org/fullstory.asp?control=1226#_edn7" name="_ednref7"><font color="black" size="2">[6]</font></a> And<br />
as investment determines output, the negative relation is carried over to a<br />
negative relation between the rate of profit and output. And in an almost<br />
Marxist fashion, output is in a 1-to-1 relation with employment. The liquidity<br />
trap would occur if the LM curve of the IS-LM framework is horizontal, making<br />
any government intervention in the money market futile. The government can't<br />
simply save the economy from itself, and the economy is caught in a trap.</font></font><br />
<br />
<br />
<br />
<br />
<font color="black" size="2">Thus, when some commentators put forward the<br />
liquidity trap as an explanation of the Japanese problems from 1990<br />
onward, they are implicitly assuming that there is a negative relation between<br />
the rate of profit and investment. According to this view, when investment<br />
rises, profit falls, and when investment falls, profit rises. Let's see if<br />
this relation holds for Japan in the 1990-2001 period.</font><br />
<br />
<br />
<br />
<br />
<font color="black" size="2">Figure 1 shows the rate of profit, both actual<br />
and forecasted, and the changes in the volume of operating profits in Japan<br />
1990-2001 (left axis). The figure also shows the percent changes in the net<br />
investment for the same period (right axis). As the figure reveals, the<br />
relation has been far from negative. Rather, the data reveals that the<br />
relation is positive. When investment falls, profit falls, and when investment<br />
rises, profit also rises. </font><br />
<br />
<br />
<br />
<br />
<font color="black"><font size="2">The evidence is conclusive—Japan<br />
hasn't been caught in a liquidity trap.</font><a title href="http://www.mises.org/fullstory.asp?control=1226#_edn8" name="_ednref8"><font color="black" size="2">[7]</font></a><font size="2"><br />
Moreover, since the relation has been positive rather than negative in what is<br />
believed to be the schoolbook example of a liquidity trap, clearly refuting<br />
the trap idea itself, the evidence should end all discussion about the risk<br />
the trap could spread to the U.S. and elsewhere. In addition, the fact that<br />
the relation has been positive rather than negative, implying that the MEC and<br />
IS curves should generally be sloping upward instead of downward, the<br />
foundations of the Keynesian and Hicksian IS-LM analysis are shaken or even<br />
collapsing.</font></font><br />
<br />
<br />
<br />
<br />
<font size="2">Reisman (1996, Chap. 18) provides a plausible argument for<br />
the positive relation between profits and investment, arguing that the<br />
relation is almost 1-to-1 in dollar terms. This follows since profit is the<br />
difference between sales revenue and costs while net investment is the<br />
difference between productive expenditure and costs (productive expenditure is<br />
the expenditure on goods and labor made by businesses). Under normal<br />
circumstances, sales revenue and productive expenditure very much changes in<br />
the same manner, resulting in a positive relation</font><a title href="http://www.mises.org/fullstory.asp?control=1226#_edn9" name="_ednref9"><font color="black" size="2">[8]</font></a><font size="2">.</font><br />
<br />
<br />
<br />
<br />
<font size="2">The unrealistic assumptions of the IS-LM analysis help<br />
explain why Krugman (1998b) has such problems of applying the liquidity trap<br />
to Japan. For example, he changes investment on the horizontal axis to<br />
consumption, i.e. the exact opposite of investment. In a way, this could be<br />
seen as indication of the fact that Krugman also has come to see that the<br />
Keynesian ideas need serious revision (although perhaps of another kind than<br />
the one suggested by Krugman).</font><br />
<br />
<br />
<br />
<br />
<font size="2">Figure 1 - The rate of profit, both actual and forecasted,<br />
and the <i>changes </i>in the volume of operating profits (left axis) vs. the <i>changes<br />
</i>in net investment (right axis), Japan 1991-2000.</font><br />
<br />
<br />
<p align="center">[img])
<font size="2"><em>Sources: The Bank of Japan Tankan—Short-term Economic
Survey of Enterprises in Japan (rate of profit) and the Economic and Social
Research Institute (net investment and volume of operating profits).</em></font>
<font size="2">It is highly unfortunate that the Keynesian ideas have
dominated the monetary and fiscal policies pursued in Japan during the period
under scrutiny, including interest cuts down to zero, serious monetary pumping
and assorted fiscal measures. It should come as no surprise to the reader that
these policy measures have utterly failed. But as I argue in a recent report (Johnsson
2003), these Keynesian measures were not only ineffective, and not only
worsened things, but even managed to turn a favorable development of the mid
1990's around. The end result of these Keynesian monetary and fiscal policies
was exactly the terrible situation one perceived one was combating!</font>
<font size="2">The Keynesian policy measures will not work in the future
either, despite the advice of Neo-Keynesians like Nobel laureate and former
World Bank chief economist Joseph Stiglitz or popular economist Paul Krugman.</font><a title href="http://www.mises.org/fullstory.asp?control=1226#_edn10" name="_ednref10"><font size="2">[9]</font></a><font size="2">
Keynes wrote in the preface to his General Theory that"I cannot
achieve my object of persuading economists to re-examine critically certain of
their basic assumptions except by a highly abstract argument and by much
controversy."</font>
<font size="2">He ends the same preface by stating that"[t]he
difficulty lies, not in the new ideas, but in escaping the old ones."
Maybe these words have taken on a new meaning, this time meaning that it is
Keynes' own ideas we have to escape? Or as Reisman (1996) puts it:"The
Keynesian analysis is so wrong that it is beyond redemption. The one,
fundamental change that is needed is its total abandonment."</font>
<font size="2">------</font>
<font size="2">Richard C.B. Johnsson works at The Ratio Institute in
Stockholm, Sweden. He earned a Ph.D. in economics in March 2003 at the
University of Uppsala, Sweden, after successfully defending a thesis that
included the construction and application of a Computable General Equilibrium
(CGE) model. Contact author at </font><font size="2">richard.johnsson@ratioinstitutet.nu</font><font size="2">
or visit his personal website .</font>
<a name="_Toc40175159"></a><a name="_Toc39849476"><font size="2">References</font></a>
<font size="2">Hazlitt, H. (1960). The Critics of Keynesian Economics,
(ed). Princeton, N.J., 1960.</font>
<font size="2">Hicks, J. R. (1937)."Mr. Keynes and the Classics: A
suggested simplification." Econometrica.</font>
<font size="2">Johnsson, R. (2003)."Deflation—Some Classical
Lessons." Working Paper No. 23, The Ratio Institute, 2003. Available at
http://swopec.hhs.se/ratioi/.</font>
<font size="2">Keynes, J.M. (1936). The General Theory of Employment,
Interest and Money. New York: Harcourt, Brace.</font>
<font size="2">Krugman, P. (2003)."No
Relief in Sight." New York Times, 2.28.03</font>
<font size="2">—. (2001)."After The Horror." New York Times,
9.14.01.</font>
<font size="2">—. (1998a). Why Aren't We All Keynesians Yet?"
8/3/98. Available at (http://www.pkarchive.org/theory/keynes.html)</font>
<font size="2">—. (1998b)."Japan's
trap." May 1998.</font>
<font size="2">Lahart, J. (2003). Trapped
like Japan?, CNN/Money Senior Writer, May 9, 2003.</font>
<font size="2">Reisman, G. (1996). Capitalism: A Treatise on Economics.
Jameson Books, Ottawa, Illinois.</font>
<font size="2">Reuters. (2003). Weaker yen may help Japan deflation
fight-Stiglitz, April 14, 2003.</font>
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<div id="edn1">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref2" name="_edn2"><font size="2">[1]</font></a><font size="2">
See for example Lahart (2003). See also Krugman (1998b).</font>
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<div id="edn3">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref3" name="_edn3"><font size="2">[2]</font></a><font size="2">
See Keynes (1936) and Hicks (1937).</font>
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<div id="edn4">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref4" name="_edn4"><font size="2">[3]</font></a><font size="2">
Keynes (1936), Chapter 11, II.</font>
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<div id="edn5">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref5" name="_edn5"><font size="2">[4]</font></a><font size="2">
Keynes (1936), Chapter 13, II.</font>
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<div id="edn6">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref6" name="_edn6"><font size="2">[5]</font></a><font size="2">
Keynes (1936), Chapter 11, III.</font>
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<div id="edn7">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref7" name="_edn7"><font size="2">[6]</font></a><font size="2"> <font color="black">There
are some major modifications, like the fact that Hicks (1937) denotes
investment as depending on a single interest rate/rate of profit. The
IS-curve isn’t really a curve but rather an equilibrium locus, where
demand meets supply. But the underlying idea is still the same
as Keynes’s.</font></font>
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<div id="edn8">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref8" name="_edn8"><font size="2">[7]</font></a><font size="2">
As shown in Johnsson (2003), it doesn’t matter if one instead compares
the rate of profit to the Gross Domestic Product, or even Gross Investment
or Gross Domestic Revenue according to the Reisman (1996) framework.</font>
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<div id="edn9">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref9" name="_edn9"><font size="2">[8]</font></a><font size="2"> And
it is this argument that prompted the present author to inquire into the
situation in Japan. S<font color="black">ee also for example Hazlitt
(1960) for further criticism of the Keynesian ideas.</font></font>
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<div id="edn10">
<a title href="http://www.mises.org/fullstory.asp?control=1226#_ednref10" name="_edn10"><font size="2">[9]</font></a><font size="2">
According to Reuters (2003), Stiglitz the same day said, “the Japanese
government could stimulate domestic demand by printing money, in a form
similar to U.S. treasury paper.” That is, above the money printing
conducted by the Bank of Japan. According to Krugman (1998a, 2001 and
2003), the problem is too little spending regardless of what kind, so that
the spending in connection to the destruction of skyscrapers or even war
is good for the economy.
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