Krugman’s liquidity trap claptrap

Free market capitalism is the best system of economic organisation ever devised. The 20th century demonstrated that it is consistent with both material prosperity and personal freedom. However, the Great Depression and the more recent Great Recession were major setbacks, which suggested that contemporary capitalism might be vulnerable to macro-economic instability.

Critics of the free market often focus on alleged inadequacies of the financial system, not least because it is this system that is distinctively capitalist. A common allegation is that banking is particularly unsatisfactory and needs far-reaching reform of some kind or other. Related arguments are that banks’ principal liabilities, the deposits that nowadays constitute the bulk of the quantity of money, have a potentially troublesome relationship with people’s asset portfolios and expenditure behaviour.

A particularly complex argument of this sort was presented by Keynes in his 1936 General Theory. His quarrel was with the quantity theory of money and, more specifically, with Ralph Hawtrey, who in the 1930s was in effect the Treasury’s chief economic adviser. Hawtrey was a strong believer in a monetary theory of the trade cycle. He therefore claimed that increases in the quantity of money, which the state could engineer by means of open market operations, were a sufficient answer to the high unemployment then prevailing. He opposed the public works, and the wider deployment of fiscal policy, which Keynes supported.

Keynes argued that investors balance money and fixed-interest bonds in their portfolios, and that in certain circumstances this balancing could have perverse results for the wider economy. Suppose that the economy has passed through a recession, so that the price level is flat or falling, and bond yields (which Keynes called ‘the rate of interest’) are exceptionally low. Investors fear that the next move in bond yields may be upwards, which would give them a capital loss.

As a result, if the government or central bank were to inject extra money into the economy, investors would not buy bonds at a higher price (which ought to push down ‘the rate of interest’), but instead let the ratio of money to their wealth rise without limit. In the jargon, ‘the interest elasticity of the demand for money would be infinite’. So, open market operations would be unavailing and Hawtrey’s reliance on monetary policy alone would have disappointing results. In 1940, Dennis Robertson, one of Keynes’ intellectual antagonists, invented the soubriquet ‘the liquidity trap’ to describe this unfortunate state of affairs.

The catchy phrase has subsequently appeared countless times in textbooks. However, few people now read The General Theory with the care and attention that it demands, and the original meaning of the liquidity trap has been diluted almost to vanishing point. The phrase has come to be applied to any situation in which, in some sense or other, ‘monetary policy does not work’. For example, Paul Krugman, has asserted in several articles in his New York Times column – as on 14th December last year – that the world’s leading economies are in ‘a classic liquidity trap’.

According to that column, a classic liquidity trap occurs when ‘a zero short-term interest rate isn’t low enough to restore full employment’. Krugman – who won the Nobel economics prize in 2008 – is widely regarded as the USA’s most articulate and effective spokesman for Keynesian ideas. For those uninitiated in macro-economic theory his words are taken as gospel. However, the trap called ‘classic’ by Krugman is no such thing.

Krugman talks about the ‘short-term interest rate’, by which he means the interest rate set by the central bank. Yet, Keynes’ trap arises when increases in the quantity of money cannot push nominal bond yields beneath a certain level (which must be above zero) because investors have perverse expectations about the price of bonds. Krugman’s trap holds when the central bank cannot, by increasing the monetary base, cut the short-term interest rate beneath zero. That leads to an unacceptably high real interest rate if people are concerned about falling prices. Krugman’s trap is not at all a classic trap originating in the debates of the 1930s. It is an entirely new trap that he has invented. Keynes’ trap is implausible and certainly does not exist today.

Modern Keynesians are untrustworthy, if they can so wilfully misunderstand and misrepresent their supposed intellectual hero. The supposed ‘liquidity trap’ is a plaything of left-wing intellectuals, not an argument for the subversion of a hugely successful capitalist economic system. In the form suggested by Keynes the liquidity trap does not exist today. In the form suggested by Krugman, his so-called liquidity trap does not invalidate monetary policy because monetary policy can still be effective using instruments other than short-term interest rates.

Further research by Tim Congdon is available here.

Shadow Monetary Policy Committee

Tim Congdon CBE is an economist and businessman, who has for over 30 years been a strong advocate of sound money and free markets in the UK’s public policy debates. He was a member of the Treasury Panel of Independent Forecasters (the so-called “wise men”) between 1992 and 1997, which advised the Chancellor of the Exchequer on economic policy. He founded Lombard Street Research, one of the City of London’s leading economic research consultancies, in 1989, and was its Managing Director from 1989 to 2001 and its Chief Economist from 2001 to 2005. He has been a visiting professor at the Cardiff Business School and the City University Business School (now the Cass Business School). He was a Visiting Research Fellow at the London School of Economics between 2005 and 2007. He was awarded the CBE for services to economic debate in 1997. His books include Monetarism: an Essay in Definition (London: Centre for Policy Studies, 1978), Monetary Control in Britain (London: Macmillan, 1982), The Debt Threat (Oxford and New York: Blackwell, 1988) and Reflections on Monetarism (Cheltenham: Edward Elgar, 1992). In 2005 the Institute of Economic Affairs published his monograph on Money and Asset Prices in Boom and Bust, and in 2009 it published a further monograph on Central Banking in a Free Society. A collection of papers on Keynes, the Keynesians and Monetarism (Cheltenham: Edward Elgar) appeared in September 2007. His latest book, Money in a Free Society (New York: Encounter Books, 2011), is more specifically a response to the Great Recession. In June 2009 Tim Congdon set up a new economic consultancy, International Monetary Research Ltd., of which he is now chief executive. Tim Congdon was honorary secretary of the Political Economy Club from 1999 to 2010.

15 thoughts on “Krugman’s liquidity trap claptrap”

  1. Posted 29/02/2012 at 18:28 | Permalink

    Japan fell into this trap 22 years ago and things are still getting worse.

    Europe and the USA are now at the same point. In the early and mid noughties, the banks lent out 30% more than normal debt provisioning should have allowed using credit default insurance (CDO’s and CDS’s) from AIG and their like because the Central Banks and Regulators said it was OK.

    This overlending is now being unwound as we see Hestor has already retired £700 billion of RBS’s debt, but there is much more deleveraging to do. The banks are all using “synthetic securitisation” (see ) to hide their true level of horrendous leverage.

    As an example of the extent of this systemic derivative cover up of this debt leverage, in the USA, the Quarterly Derivatives Report from the U.S. Comptroller of the Currency said that J.P. Morgan, BofA, Citi, Goldman, Morgan Stanley represent 96% of the total banking industry notional derivative total of US$242 trillion (yes that is trillion, not billion).

    This is why our banks are not lending now and will not be in a position to lend anytime soon despite getting near Zero Interest rates from the Central Banks.

    Also, if Interbank rates are near Zero, there is no financial reward for banks to lend to their peers and the interbank market ceases to work or exist.

    Until the banks deleverage and clean up their balance sheets by coming clean on the true state of their books, we cannot escape this Zero Interest Rate Policy trap.

    That means accepting massive capital haircuts and defaults like Argentina and Iceland, instead of 22 years of debt penury like Japan.


  2. Posted 29/02/2012 at 18:34 | Permalink

    “Free market capitalism is the best system of economic organisation ever devised.”

    What a lot of cobblers. It is the system that has failed the general population over and over again and filled the pockets of the systems controllers.

  3. Posted 29/02/2012 at 18:51 | Permalink

    @Ragmouse – It’s important not to confuse ‘actually existing capitalism’ with genuine free-market capitalism. State intervention is now pervasive. Nevertheless, to the extent it has been permitted to operate, the market has delivered big long-term increases in living standards across most of the globe – and a freed market would bring much greater benefits on top!

  4. Posted 29/02/2012 at 20:00 | Permalink


    When 50% of GDP is public spending, it is NOT Free Market Capitalism. When government – and the EU 0 intervenes again and again in the running of businesses – it is not Free Market Capitalism. What we are currently experiencing is Corporatism, a very different beast indeed.

  5. Posted 29/02/2012 at 21:13 | Permalink

    So ,Mr. Congdon base should be 3 percent,and QE should be stopped? That is my view.

  6. Posted 29/02/2012 at 22:39 | Permalink


    Capitalism has failed the population !! As opposed to all the other systems so far tried, Fuedalism, Socialism, Communism , theocracyand fascism which as we all know are far more successful.( If the objective is killing large numbers of people)

    Cobblers indeed

  7. Posted 29/02/2012 at 23:37 | Permalink

    And today, the ECB created another €530bn, gave it to commercial banks at 1 who lent it to Governments at 5%. Free money and trebles all round!

    Slight problem in three years when it all has to be refinanced from the real world.

  8. Posted 01/03/2012 at 00:41 | Permalink

    Translation:Congdon wants to print more money.

  9. Posted 01/03/2012 at 01:28 | Permalink

    Regressive expectations of bond prices is one explanation of Keynes’s concern of the so-called liquidity trap. Another interpretation is that Keynes was saying that domestic monetary policy was constrained by the commitment to the Gold Standard, implying that longer term interest rates must revert to the global level. This second interpretation resembles the problem of being trapped in the Euro Zone, and willingly so, because the Euro is probably as much a fetish today as gold was then.

  10. Posted 01/03/2012 at 03:26 | Permalink

    Dear Tim, You are right that the financial system is very different from the one Lord Keynes was analysing. Who knows what he would say if he were alive today. However, it is entirely plausible that he would see the equivalent of his “liquidity trap”.
    In his day, securities were still mainly owned by individuals and, as you will see from Stock Exchange records of the time, most company securities were bonds, mortgage debentures or preference shares and even small companies had listed fixed income securities.
    Today, the vast majority of companies other than utilities, financial institutions and the largest corporate borrow from banks rather than (directly or indirectly) from the public. It is therefore at the bank level that a modern Keynesian would look for the liquidity trap. It is not hard to find. Banks are cautious about lending to business because of poor business conditions. Quantitative easing, by underlining fears of recession, has added to their caution and has led to a great increase in bank liquidity.
    Of course, banks are buying a great deal of bonds and driving down the price but these are overwhelmingly government bonds. That is really the purpose of QE and its equivalents, unstated at the Bank of England but overt at the European Central Bank. And because central banks are happy to buy these bonds, they are as liquid as treasury bills used to be. As emergency monetary measures continue to undermine confidence, banks have less incentive to lend to business and the rate of interest on bonds is irrelevant to most corporates.
    The main difference in the new “liquidity trap” is that monetary expansion goes to finance state deficits, which remain cyclically high because confidence in the private sector remains low. Mr Krugman is plainly wrong, however, to conclude that higher fiscal deficits financed by QE would somehow get us out of this modern liquidity trap. They would tend to drop us further in.

  11. Posted 01/03/2012 at 09:04 | Permalink

    Over and over again, I can see that modern economy is more a religion than a science. Modern capitalism and neoliberalism are new Gods to some people. I´m convinced, that modern capitalism has killed more people than any other system. It is so, because it constantly impoverishes large masses of population in all over the world, or as Joseph Stiglitz quoted it is Privatizing Profits, Socializing Losses. It wages wars with the same intensity as any other system before. There is still 1 billion people who live for less than 1 dolar a day. There is no clear connection between Capitalism and science, so you cannot say, that capitalism saves lives or helps us to get better drugs or computers.
    I don´t want to blame it that much. I´m a western citizen so I live well. To me, capitalism has delivered material well-being. But who paid for it?
    Capitalism and democracy create big levels of corruption. Business and government linkages exist in every country in the world. Citizens feel powerless and the desilusion grows bigger and bigger. There has to be some systemic change towards new system. As Immanuel Wallerstein says, this would happen in the next twenty-thirty years. And I do agree with him.

  12. Posted 01/03/2012 at 11:23 | Permalink

    @ragmouse. <>. ‘Capitalism’ has not failed at all. The most used examples of the failure of capitalism – the Great Depression and the Great Recession are not at all the result of capitalism. In one way or another they are the result of the bastardisation of capitalism by vested interests or social experimenters. In very simple terms the Geat Depression was precipitated by – among other things – the unwarranted expansion of money and credit (i.e. another example of central bank failure) and protectionism. The current Great Recession is the result of (in the UK) massive cronyism, the particular talent of New Labour; again the unwarranted expansion of money and credit; and massive central planning of the financial system following the FSMA2000 which brought in the Failed FSA which precipitated massive misregulation and the consequential failures. Add to that the supra-national Basel bank capital rules that permitted, nay encouraged, banks to massively expand their balance sheets and yet again you can see it is the failure of central planning. Add to all the above the special privilges handed to banks (and to Trades unions) neither of which would happen in proper capitalism and you can see that the truth is the exct obverse of what you assert.

  13. Posted 01/03/2012 at 11:48 | Permalink

    @Laura S. Au contraire my little lotus flower. ‘Capitalism’ (which doesn’t exist as an -ism by the way) has delivered more prosperity and health and welfare improvements than any cod political economic philosophy invented by man. Note, ‘capitalism’ was not invented by man – it is the result of man just going about doing stuff with his neighbours in a peaceable way. The most murderous desinged philosophy is socialism/communisn in whose name upwards of 80m people have been slaughtered. Stalin. Hitler, Pol Pot, Mao tse Tung, various South American gangsters, most African ‘liberation’ armies etc etc have all murderded and visited violence on their enemies and their own people in the name of some proto socialist/communist ideology, always as a cloak for their own search for power and wealth. That is they did not create any wealth, but took it by coercion and more often than not at the point of a gun.

    What we have now is not enough capitalism – that is we have seen our personal and economic freedom sequestered by self – aggrandising entitlement seeking bureaucrats and their cronyistic political arriviste masters. If you doubt this please explain to me how Blair and Mandleson got so rich whilst engaged in public service? I’ll tell you how – out and out cronyism. Oh, and who took us to war, twice?

  14. Posted 03/03/2012 at 00:27 | Permalink

    “Free market capitalism is the best system of economic organisation ever devised. The 20th century demonstrated that it is consistent with both material prosperity and personal freedom.”

    Except we are told in the comments that “It’s important not to confuse ‘actually existing capitalism’ with genuine free-market capitalism. State intervention is now pervasive.”

    It would mean that we haven’t had free market capitalism since the 1930s, and you can discount the years of the first world war aswell. So about 25 years out of the past 100? But then we are stuck with the problem that WW1 took place during a period of free market capitalism, and that saw millions killed aswell.

    The Scando chap over at the ASI who recently wrote that everything in the past 20 years was good and wonderful under capitalism used an example from Brazil to illustrate his fantasy.

    Except that Brazil has had a social democratic government for most of the past 20 years. Errr…

    “Note, ‘capitalism’ was not invented by man – it is the result of man just going about doing stuff with his neighbours in a peaceable way.”

    In which case it was an invention of man. Unless you are trying to claim that free market capitalism is the natural state of man.

    But all the great economic classical theorists from Petty to Smith and Ricardo were analysing a system that was emerging from feudalism and were clear on its differences.

    Your attempt to make capitalism ahistorical is no different from slave owners who claimed slavery was a natural state of man.

    All this free markets will make you wonderful and have existed for ever is a) economically and historically ignorant and b) like something out of Candide.

    PS liquidity traps. There in Capital vol III, by K Marx. Explains it all very well.

  15. Posted 11/08/2013 at 19:35 | Permalink

    I think Congden wilfully misunderstands and misrepresents Krugman & Keynes. Firstly Krugman does not restrict his concept of the liquidity trap to zero bound short rates – he argues that the Treasury bond curve is effectively zero bound because there is option value to bonds that prevent the yield falling even lower. This is actually pretty similar to Keynes’ articulation of the liquidity trap: his version kicks in when bond prices are not expected to rise further (ie when the yield is already very low & cannot fall much more); in such circumstances the demand for money (liquidity preference) may be very high thus rendering Central Bank increases in the money supply ineffective as a means to increase aggregate demand. So Krugman & Keynes are actually saying the same thing.

    Where I’d agree with Congden is that monetary policy can still be effective ‘using other instruments’. It’s just that government bonds, when de facto zero bound, are not effective instruments and therefore QE in such circumstances needs to involve other asset types (MBS – as per Fed policy – or equities, corporate bonds, bank loans etc). But I find it utterly depressing that Congden dismisses the whole concept as a ‘play thing of left wing intellectuals’ … that is pure misrepresentation, wilful or otherwise.

Comments are closed.