Effective demand, liquidity traps and debt deflation

Paul Krugman has laid into Ben Bernanke, the head of the US Federal Reserve, for stopping his previous policy of easy money and quantitative easing.  By pausing, Krugman reckons that the Fed could allow the US economy to slip back into recession: “He has not done remotely enough. The Fed, under its eminent chairman, was supposed to be an important part of the solution to mass unemployment. That isn’t happening.” (http://www.nytimes.com/2012/04/29/magazine/chairman-bernanke-should-listen-to-professor-bernanke.html?pagewanted=4&_r=1&ref=magazine).

The thing is that Ben Bernanke is not a Keynesian.  He is really a follower of Milton Friedman, the deceased right-wing Chicago economist and adviser to the Chilean dictatorship of General Pinochet in the 1980s.  Friedman started off as a Keynesian, but eventually argued that depressions are caused by the lack of sufficient money supply (the quantity theory of money).  Central banks need to get the right amount of money supply in an economy to get it to grow at full employment: too little and you have a recession or even depression as in the Great Depression; too much and you get inflation.  So recessions are the fault of central banks.

Bernanke agrees with this theory.  As he said at Friedman’s 90th birthday tribute: “regarding the Great Depression, you’re right.  We did it.  But thanks to you, we won’t do it again.”  He meant that the Great Depression was the fault of a Federal Reserve that released too much money into the economy and then took it away too quickly.  Now Bernanke wants to avoid a debt deflation, where debt rises in real terms because inflation turns into deflation in a slump.  But he also wants to avoid inflation.  Right now, at least according to his latest Fed statement last  Wednesday, he is not sure which way the economy is going.  So he is sitting on his hands and pausing on any further quantitative easing.  Bernanke  said in his press conference that his current policy, given that there is inflation, is completely consistent with his old views on the Great Depression.

Krugman wants more action, presumably more QE, as he reckons  the economy is in a Keynesian ‘liquidity trap’, where companies are not investing and households are not spending and instead are ‘hoarding’ cash, even though interest rates are near zero (at least from the Fed) and borrowing is cheap.  For Keynesians like Krugman, government spending is fine under certain conditions: when there is liquidity trap; when there is high unemployment and when the lack of demand persists.  Then the multiplier effect on GDP growth from more spending can be high (see Pontus Rendahl, A case for balanced budget stimulus, 26 April 2012, http://www.voxeu.org).

The Modern Monetary Theory (MMT) guys reckon that it does not take a liquidity trap to prolong a depression.  If there is no demand for credit, then no amount of leading a horse to the trough will work.  So the MMT guys want fiscal action through more government spending.  As Bill Mitchell put it in his blog (http://bilbo.economicoutlook.net/blog/): “The Modern Monetary Theory (MMT) does not rely on the existence of a “liquidity trap” (however conceived) to make a case for the effectiveness of fiscal policy. Paul Krugman and others, who currently advocate the the use of fiscal policy, only do so because they claim there is a liquidity trap which renders monetary policy ineffective. However, in normal times they advocated the primacy of monetary policy.  MMT can demonstrate the ineffectiveness of monetary policy outside of a liquidity trap. The reality is that policy makers have very little idea of the speed and magnitude of monetary policy impacts (interest rate changes) on aggregate demand. There are complex timing lags given how indirect the policy instrument is in relation to its capacity to influence final spending.  Further there are unclear distributional effects – creditors gain when rates rise, debtors lose. What will be the net effect? Central bankers do not know the answer to that question. Monetary policy is also a blunt policy instrument that has no capacity to target specific segments of the spending population or regions.  We always knew that. …  By continuing to see quantitative easing as the solution, the more progressive mainstream economists have also caused the current crisis to be extended.”

That brings me back to my previous post (Paul Krugman, Steve Keen and the mysticism of Keynesian economics, 21 April 2012) and taking it a little further.  Some comments on my last post on Keynesian economics suggested that I had been too harsh on Keynes and his followers, not distinguishing clearly enough between ‘New’ or ‘Post-Keynesians’ who had watered down Keynes so his theory could be synthesised with neo-classical economics.  Keynes, himself, was much more radical, says Krugman.  Well maybe.  Keynes himself considered his ideas as “moderately conservative in its implications”.  But then Keynes changed his views and his opinions on a regular basis.  Once, when questioned about his inconsistency by his neoclassical critics, he said “well, when the facts change, I change my ideas, don’t you?”.  The trouble is it depends on whether the facts have changed or just your view of them.

One of the main issues for me is whether Keynesian claims about the lack of ‘effective demand’ constitute a causal theory of crisis or just a tautology.  Is not the lack of effective demand really a description of a slump rather than its cause?  Paul Krugman, in a little piece called Reading Keynes, tells us that where aggregate demand intersects with aggregate supply, we can find ‘effective demand’ and this equilibrium point could be well below that necessary for full employment in an economy.  This is the key argument of Keynes against the neoclassical school of economics, who claim that supply will create sufficient demand to avoid unemployment.  This is Keynes refuting the fallacy of the so-called Say’s law that claims supply creates its own demand. This is supposed to be startlingly new, although several economists in the 19th century, including Marx, had already shown this.

In his well-known (among economists) attack upon the failure of neoclassical economics to explain economic recessions and particularly the Great Recession (How did economists get it so wrong? 6 September 2009, NYT Magazine), Krugman presents his ‘co-op babysitting’ example. He says “a recession is a problem of inadequate demand.  There isn’t enough babysitting demand to provide jobs for everyone who wants one.”  But this is not an explanation, but a description.  Inadequate demand arises in the baby coop because people hold onto the money rather than buy babysitting services.  This is really yet another refutation of Say’s law.  All it shows is the possibility of a breakdown between buying and selling because of money.  Marx had described that possibility over 150 years ago.  It’s not new.  But in Krugman’s example, there is no explanation of why or when the coop starts hoarding money rather than spending it; it just starts happening.  Krugman puts it down to ‘irrational’ people and ‘imperfect’ markets (the latter, a neoclassical explanation).

It’s the same problem with the explanation of depression as due to a liquidity trap i.e we get to ‘zero bound’ interest rates and there is still no new spending on investment or consumption.  This liquidity trap can be shown by the ‘velocity of money’ in an economy.  Look at this graphic.  It tells the same story as the money multiplier graphic in my last post.

In the Great Depression, the economy becomes ‘stuck’ in a trap of unwillingness to spend – the velocity of money line is well below average.  This is the problem, says Keynes and Krugman.  Yet in the Great Recession, according to the graph, the liquidity trap is not so obvious.  And anyway, why has it happened?  Because there is an unwillingness to spend!  In other words, there appears to be no rational explanation for why the velocity of money drops suddenly in the Great Depression or the Great Recession except that it does.  But in a capitalist monetary economy, such hoarding can be perfectly rational if we connect with a fall in profitability for investment.  Then there is less confidence to invest further and hoarding starts.  Look at the current state of affairs, with US corporations building up huge cash piles and investing relatively less (see my post, Why is US recovery so weak?- look at profitability, 3 April 2012).

The Austrian school of economists argue that the slump in investment is due to previously excessive credit expansion that is now bursting.  The Minsky school says much the same (as does Steve Keen – see my last post).  Those who believe this have attempted to measure the point at which excessive credit or debt becomes the tipping point for a crisis.   The economists Reinhart and Rogoff have done so; the IMF has done so and apparently so has Steve Keen (see my post, Riccardo Bellofiore, Steve Keen and the delusions of debt, 7 October 2011).

Irving Fisher was the ‘debt deflation’ economist of the interwar period.  He reckoned that there were waves of excessive credit or debt, which eventually led to ‘debt deflation’ ie falling prices drive up the real value of debt and so painful deleveraging must follow to reverse the excess. This is the main reason for booms and slumps.  So debt matters.  Krugman seems to recognise that there could be “debt-driven slumps”.  In 2010, he wrote a piece with Gauti Eggertsson (Debt, deleveraging and the liquidity trap, 16 November 2010) that argued an “overhang of debt on the part of some agents who are forced into deleveraging is depressing demand.”  From that debt deflation (Fisher-style), the liquidity trap and the Keynesian multiplier emerge.  And this provides a “rationale for expansionary fiscal policy”.  Krugman called it a Fisher-Minsky,Koo approach to the crisis, although Steve Keen has remarked that he could find little of Minsky in the paper (remember Krugman has little time for Minsky’s financial instability theory).

Yet more recently, Krugman appeared to deny the role of debt in crises.  Krugman says it does not matter in a ‘closed economy’ i.e. one where one man’s debt is another’s asset.  It’s only a problem if you owe it to foreigners.  But the IMF disagrees.  In its latest World Economic Outlook, April 2012, IMF researchers take Krugman to task.  The IMF outlines the evidence that debt does make a difference both to the depth of the crisis and the strength of the recovery: “recessions preceded by economy-wide credit booms tend to be deeper and more protracted than other recessions”  (p96) and “housing busts preceded by larger run-ups in gross household debt are associated with deeper slumps, weaker recoveries and more pronounced household deleveraging“, p115).

Indeed, there is no guarantee that an economy will come out of a slump.  That’s why Fisher misread the slump of 1929.  He thought would be over in a moment, once debt had been cleared.  Instead, it took a war ten years later to do it.  This time too, the clearing of both ‘dead capital’ in production and fictitious capital in finance is going to take a long time.  So we are in what is really a ‘long depression’ as in the 1880s in the UK and the US.  The great boom then  (or ‘great moderation’ now) of 1850-73 (1982-97 now) came to end in a big crash (1873 then, 2007 now), and subsequently it took a series of slumps (1879, 1883, etc or 2008-9) to clear the decks for renewed profitability before capitalism entered a new period of growth from the 1890s onwards. The long depression of the 1880s did not lead to a world war, but to the massive extension of imperialism that helped to get capitalism going (that later ended in war).

So it is no surprise to find that the best way to clear this excessive debt is to default.  A recent study by the IMF on private and public sector debt found that the easiest way to get debt under control in the absence of fast economic growth (current conditions) was to default! (IMF special paper, Default in today’s advanced economies,  2010).

So let’s sum it up.  What is the cause of booms and slumps or economic recessions or depression?  The dominant neoclassical school of economics says any slump is due to imperfections or ‘frictions’ in the market place (namely trade unions or governments disturbing the labour market or monopolies distorting product markets).  In other words, when so-called ‘efficient markets’ are no longer efficient.

Keynesians reckon it is caused by the lack of ‘effective demand’, which happens by chance or by ‘irrational’ behaviour on the part of ‘economic agents’, who suddenly hoard money rather than spend it.  Sometimes this can lead to a ‘liquidity trap’ at ‘zero bound levels’ of interest-rates and so prolong a recession into a depression.

The Minsky school says the cause is an inherent instability in financial sector due to excessive risk-taking that generates a build-up of debt that cannot be honoured.  The Austrian school says this excessive credit is caused by government and central banks creating it.  Both say deleveraging of this debt prolongs a slump.

Some Marxists reckon crises and slumps are not caused by a lack of effective demand or excessive debt or financial instability, but by falling and low profitability in production.  The impact of falling profitability can be postponed by credit (fictitious capital) expansion, but then the eventual slump will be exacerbated by the need to clear this excessive debt.  This is my view.   Other Marxists reckon the crisis is due to ‘the anarchy of capitalist production’ (that’s too vague and too high a level of abstraction as an explanation for me). Or some say it is due to ‘underconsumption’, or a lack of spending power by workers.  That’s pretty much the Keynesian view (just a description of a slump not an explanation).

9 Responses to “Effective demand, liquidity traps and debt deflation”

  1. paulc156 Says:

    There seems no obvious reason why all these explanations might need to coincide to some extent in order to get a prolonged slump.
    Low profitability combined with unequal distribution of income and consequent indebtedness would seem reasonable. That profitability plays a fundamental part seems credible but presumably low profitability itself is not independent and therefore is no less circular a proposal than ‘lack of demand’?
    Perhaps with greater equality of income and less favourable tax treatment of debt [for business] we would in any case have greater final demand/investment and therefore profit!
    It just doesn’t seem perfectly clear why ‘profitability’ alone stands above the other variables.
    I also wonder whether technological advances are dependant on these same economic variables or rather more exogenous. Do we need more invention? It seems that computerisation provided a great deal of investment and subsequent production and that we are simply in need of some other such breakthrough technology.
    Or does technological advancement lag economic growth or is it simply irrelevant?

    • michael roberts Says:

      Profitability stands above other ‘variables’ both for theoretical and empirical reasons. Marx’s law of value centres on the creation of profit from labour power and the appropriation of value created by labour by capitalist ownership of the means of production. It is the starting point of the explanation of the capitalist mode of production and underlies all the law of motion under capitalism. Mainstream economics (both neoclassical and Keynesian) deny a role for profits except as the result of the return on capital (noeclassical) or a product of investment (Keynes). That’s the theoretical flaw in mainstream economics. Empirically too, the crisis cannot be explained without profitability. Using consumption or debt as variables without profitability is flawed. The Great Recession took place when consumption and investment were at peaks and debt too. Why then was there a slump? Measuring profitability reveals the answer.
      Technology is essential for capitalism to get profits up but the contradiction is that eventually it will lead to a fall in profitability, according Marx’s law. So capitalist will then have destroy the value of existing capital to start again. Capitalists will need new breakthroughs.

  2. Edgar Says:

    Could the high price of ‘necessities’ cause slumps in your opinion? In Britain fuel is taking up an ever greater % of household spend, therefore there is less to spend on other products.

    • michael roberts Says:

      Edgar

      if you mean that higher prices for fuel eat into spending power and cause real incomes for households to fall, then that would not be a reason for a slump. Higher fuel prices could mean higher profits for fuel providers which could boost investment. of course it could also higher costs for those capitalists that use fuel and so reduce profits for the. A general rise in raw materials costs that have to be imported will reduce profitability for British capitalists other things being equal.

  3. Chris Hughes Says:

    thank you for your blog Michael, it is very informative

  4. lbattisti80 Says:

    I have sometimes the impression that you don’t care a lot of the realization of profit. Once that a capitalist has taken plus-labor from workers and has turned it in plus-value, he has to realize it on the market. If, for some ideal reason, there is no demand on the market, he has no way to realize the profit. Let’s say i open a factory of ice in north pole. Who is going to buy it? On the other hand, even if i produce a good who has a market, and for some reason there is no demand, the result is the same. And since i don’t sell my goods, the profitabilty fall. But it’s not a fall tied to the production process (as marx in the first book said and the one you seem to refer), but a fall in demand. Why is it falling? I tend to think that marx is a great thinkers, but he is not perfect as anyone of us. So i consider that some bourgeois economist can provide some clue and interesting analysis on certain aspect of our economy.

    • michael roberts Says:

      Yes if you cannot sell your goods, then you wont realise a profit as capitalist and you may even make such a loss as to go bankrupt. But the question is why does demand suddenly fall? Is it by chance? Or is there a more objective reason? When demand falls, the capitalist cant sell goods or services and does not make a profit to match invested capital. But that’s a description of a slump not an explanation of why it happens on a regular basis.

      • Mike B) Says:

        Maybe it happens on a regular basis because real wages aren’t rising quickly enough to keep pace with real productivity. The replacement of real wage increases with credit e.g. credit cards amongst the working class and default swaps etc between the finance capos, pump up the price bubbles above concrete values produced via socially necessary labour time. When credit bubbles burst, markets collapse.

        The declining rate of profit is related to the increase of real productivity and the cheapening of commodities for sale, isn’t it? If so, an increase in real wages might partially resolve the issue of ‘job creation’ via QE by increasing effective demand, no?

        Certainly, QE and vast amounts of other fictious capital lowers the price of the money it is issued in. The USD has gone down, down, down in market price in relation to other currencies since the dot.com bubble burst back in late 2000. This should have done something to resolve the balance of trade in the ensuing years and probably has. Still, finding enough market demand to buy real values based on SNLT has not kept pace, hence a general declining rate of profit. Might that market demand be enhanced by raising real wages? Might a rise in real wages be a result of imposing legal limits on the work day?

        Happy May Day!

  5. Choppa Morph Says:

    Interesting comparisons of different bourgeois approaches.
    As for the cause of slumps, the orthodox Marxist view has to be over-production. The market is glutted. And not just with goods, but with capital. Falling profits result from excess capital.
    So consumers don’t start buying again until the surplus goods are out of the way and need/demand is felt again. And capitalists don’t invest until the surplus capital is out of the way. Surplus goods are dumped or destroyed, surplus capital can be wiped out by bankruptcy, default, or most efficiently, war. (In the initial stages of such destruction bubble capital – the fictitious stuff – vanishes in a puff of vapour.)
    Too much real capital is too valuable for society to just go to waste – we should expropriate it and use it for our own purposes without the artificial constraint of “profitability”. Same as we should confiscate all the surplus products and put them to use rather than let capitalists destroy them.
    The ironic thing about observing bourgeois economists is that they care less about what they say than we seem to😉 Eugene Preobrazhensky puts it this way in The New Economics (1926):
    ” … in a capitalist country ceaseless chattering and squabbling goes on in parliament… in the sphere of science every self-respecting bourgeois economist and financial expert considers it his duty to cut a dash with paradoxes of his own invention, so as to distinguish himself from the rest… bourgeois society can permit itself such luxury in government and in science *because the function of regulating the economy, more intelligently and reliably than all the politicians and professors put together, is carried out by the law of value*. Not only the selfish class interest of the bourgeoisie (as Marx showed so clearly), but also the very *structure* of capitalist production reduce economics to, at best, the role of an apparatus for photographing the current situation, or something tolerated as a smart luxury. The mistakes of bourgeois economists can have very little effect on the successes of capitalist accumulation.”
    (Oxford 1965, p 68-9, P’s emphasis)

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