Great Leap Forward

Reconciling the Liquidity Trap With MMT: Can DeLong and Krugman Do the Full Monty With Deficit Owls?

In recent days both Brad DeLong and Paul Krugman have written good pieces arguing against the austerity marketed by deficit hyperventilators. We can thank Thomas Herndon’s muck-raking that pushed the topic front and center, showing that there is no empirical evidence in support of the austerian’s claim that big government debts slow growth. (See my previous blogs here and here).

Here’s Krugman’s argument. To briefly summarize, historical experience has demonstrated that the “growth through austerity” argument is false. Further, the monetarists have also got it wrong: monetary policy won’t get us out of this recession trap; what we really need is a good dose of fiscal policy. Given that we are in a “liquidity trap”, we can safely expand government spending without worrying about the usual downside to deficits. And in a liquidity trap, there is really no difference between Modern Money Theory and the conventional ISLM analysis. It is only once we return to a more “normal” situation that budget deficits would “matter” in the sense that they’d cause problems.

DeLong amplifies the argument here. Once we’re out of the liquidity trap, then sustained budget deficits will push up interest rates and crowd-out private spending (especially investment). This is basic ISLM stuff. For those who have not taken intermediate macro, it is enough to know that in current conditions increasing budget deficits will not raise interest rates because the private sector welcomes all the liquid and safe government debt it can get. Further, flooding the economy through Quantitative Easing will not cause inflation because, again, everyone wants liquidity and would rather hold it than spend it. In more normal times, budget deficits and money helicopters would cause inflation and rising interest rates. And that would be bad.

Note, both of them raise additional good arguments against the R&R results and against austerity more generally. I am focusing in on the one point about the liquidity trap for the purposes of this blog simply because it seems to be the sticking point that prevents them from fully embracing MMT. From the perspective of Krugman and DeLong, MMT is fine for the liquidity trap, but wrong for the normal situation—when deficits will matter.

While many economists think the ISLM liquidity trap derives from J.M. Keynes that is actually not true. Here’s what he said (Ch 15 of the General Theory):

Nevertheless, there are two reasons for expecting that, in any given state of expectation, a fall in r will be associated with an increase in M2. In the first place, if the general view as to what is a safe level of r is unchanged, every fall in r reduces the market rate relatively to the ‘safe’ rate and therefore increases the risk of illiquidity; and, in the second place, every fall in r reduces the current earnings from illiquidity, which are available as a sort of insurance premium to offset the risk of loss on capital account, by an amount equal to the difference between the squares of the old rate of interest and the new. For example, if the rate of interest on a long-term debt is 4 per cent, it is preferable to sacrifice liquidity unless on a balance of probabilities it is feared that the long-term rate of interest may rise faster than by 4 per cent of itself per annum, i.e. by an amount greater than 0.16 per cent per annum. If, however, the rate of interest is already as low as 2 per cent, the running yield will only offset a rise in it of as little as 0.04 per cent per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level. Unless reasons are believed to exist why future experience will be very different from past experience, a long-term rate of interest of (say) 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.

Sorry for that. Let me translate: while the Fed can push the short term rate to a really low level (think ZIRP), there’s a limit to how low it can push the longer rates. The problem is that we “know” we will not have ZIRP forever, and when short term rates rise, there will be capital losses on longer maturity debt (that is stuck with today’s low rate). So in this environment, no matter how much QE we get, we cannot push long rates lower. It is a “liquidity trap”—banks will hold the excess reserves and earn, say, 25 basis points rather than plunging into 30 year bonds that pay, say, 2 percent, due to fear of capital losses.

Keynes’s liquidity trap argument is not relevant to the ISLM result that when the LM curve is NOT horizontal, deficits raise rates. And it is that ISLM result that is contestable.

(I won’t go into the problems with ISLM analysis; even the creator of the model, John Hicks, later rejected it. We’ve known since the 1970s that it is an incoherent mess. It really is not taken very seriously anymore and I cannot explain why Krugman clings to it. Even in its updated form—a three equation “new consensus” model—it is still a mess with real rates and Taylor rules and imagined trade-offs.)

As MMT teaches, the operational function of selling Treasuries is to offer a higher interest earning alternative to low earning reserves (recall that until the GFC reserves paid zero; now they pay a positive rate chosen by the Fed). How much higher? Well that depends on the maturity and the state of liquidity preference. As Keynes implies, when you’ve got ZIRP you’ll have to pay about 200 basis points to get banks or others to give up liquidity to hold longer maturities. When short term rates are higher and are expected to fall, the premium required on long term maturities is lower (you can even invert the yield curve structure, with short rates above long rates).

The great fear is that if the government continues to run sustained budget deficits even after recovery, it could get into a debt trap. Trying to finance those deficits supposedly pushes up interest rates paid by government, which increases debt service costs, which accelerates the growth of budget deficits and raises interest rates more. You get the picture: a vicious cycle that increases the debt-to-GDP ratio. Eventually the bond vigilantes foreclose on the US government and we’re forced to grovel like Greeks.

But that argument misses the point. Short term rates are determined by monetary policy. The Fed can pay what it wants on reserves and charge what it wants on lending at the discount window. It targets the fed funds rate and keeps it within the bounds more-or-less set by the other two rates. When the economy begins to expand, the Fed will most likely raise rates. (And while it might raise rates in response to budget deficits, that is clearly a policy decision, not something that markets do to us.)

Deficits increase bank reserves and sustained deficits will result in excess reserve positions unless countervailing action is taken. Excess reserves put downward pressure on the fed funds rate. The Fed can sell government bonds (open market sale) to relieve that pressure, or the Treasury can sell new bonds. In either case, the operational impact is to substitute Treasuries for excess reserves (it is the opposite of QE). And note that if no such action is taken, budget deficits PUSH INTEREST RATES DOWN, not up.

What interest rate will Treasury need to pay to sell those Treasuries? Well, it depends on the maturity of the issues and the state of liquidity preference at the time. The Treasury could choose to sell short term obligations (bills) at a rate that tracks the Fed’s target rate; or it can sell longer maturities. We call that “debt management”. But note that it is a policy choice. Not a bond vigilante choice. Vigilantes cannot force the Treasury to sell long maturities.

Could the Fed try to make us grovel like Greeks? Yes. It could do a Volcker—push rates above 20%. That could get the US government into a vicious interest rate-growing debt cycle. It would of course do the same to the private sector—whose debt ratio is already a lot higher than that of the federal government. Place your bets now on which crashes first: federal government that has the magic porridge pot, or the private sector that doesn’t.

You cannot completely rule out bad policy. That’s the bad part about democracy. And every other form of government. The good thing about democracy is you can throw the buggers out every now and then.

The problem is that most people think Fed independence is natural, desirable, immutable.

That’s an upcoming topic I’ll address later. The Fed is a branch of government and a creature of Congress. So the question comes down to this: Can the Fed go all vigilante on us, without Congress putting it back into its proper place?

16 Responses to “Reconciling the Liquidity Trap With MMT: Can DeLong and Krugman Do the Full Monty With Deficit Owls?”

BurkMay 1st, 2013 at 3:48 pm

Perhaps the better argument is that, given that solvency is never the issue, the only issue for the policy rate is inflation. So the policy rate, when the economy recovers, is going to be roughly in line with inflation in perpetuity, which means that even if interest rates rise substantially and thus call forth high servicing costs for high federal debt, the concomitant inflation will eat away the debt roughly in proportion, so that we will be in OK shape unless the policy landscape gets seriously out of whack, which can never be caused by the accumulated debt, since there is no solvency risk.

NeilWMay 1st, 2013 at 3:55 pm

Why not cut to the chase and nationalise the Federal Reserve properly?

The Bank of England is owned entirely by HM Treasury, ie it's 'de jure' a subsidiary of the fiscal arm of government.

The Bank of England Act 1998 removes the ability of HM Treasury to direct monetary policy and instead gives the Bank objectives.

"In relation to monetary policy, the objectives of the Bank of England shall be—

(a)to maintain price stability, and

(b)subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.

And that structure has allowed the Bank to make as big a hash of things as the Federal Reserve even with a 'support the government' line in their terms of reference.

L. Randall Wray L. Randall WrayMay 1st, 2013 at 5:18 pm

Hi RV (nice hat!) and Burk: since you’ve argued opposite sides let me say this: in a low private debt economy, raising rates is stimulative since it increases govt spending on interest adding to private sector income. But ours is a high private debt economy so the downside is you trigger private defaults. In any case, I do not believe the story that monetary policy can be used to target inflation; and indeed its effects are sometimes opposite to what is presumed.

L. Randall Wray L. Randall WrayMay 1st, 2013 at 5:20 pm

neil i’ll write on supposed fed independence. really amounts to nothing more than rate setting. i’d take that away to ensure we don’t have the fed going volcker on us ever again.

RVMarkovMay 1st, 2013 at 5:47 pm

Thank you, professor, and thank you for the hat compliment!

So monetary policy is like the white wine, and we, the Bulgarians, have a saying:

"All the songs are written about red wine. There is only one song about white wine and it is called: "White wine, white wine why aren't you red?!" 🙂

A year or so ago Cullen Roche of Pragcap didn't like much my joke about monetary policy and the white wine. 🙁

olly100May 1st, 2013 at 7:52 pm


Are banks or primary dealers allowed to borrow directly from the Fed (via the discount window or other such credit facility) to buy bonds directly from the Treasury (at auction)?

If they are allowed, do they do this often? If not, why not?


senexxMay 1st, 2013 at 11:54 pm

I realise if I continue on the central bank independence topic, we get somewhat distracted from the point of the post but I like the way Charles Goodhart put it in a recent INET speech. Central banks have operational independence but not goal independence.

L. Randall Wray L. Randall WrayMay 2nd, 2013 at 1:11 am

The dealers must buy the treasuries. That is why it is so silly to say the vigilantes can shut down treasury. I think Fed allows float; but any bank can borrow directly from Fed.

L. Randall Wray L. Randall WrayMay 2nd, 2013 at 1:12 am

Close. they have operational independence in that they can choose the interest rate target. I’ll explain all this later in a blog (finishing the paper now)

olly100May 2nd, 2013 at 10:38 am


I was wondering why banks/primary dealers don't always just borrow directly from the discount window to buy treasuries. Why does the Fed do OMOs to add reserves instead (as you describe in "MMT – a response to critics")?

OligopoplynowMay 2nd, 2013 at 1:22 pm

Why not just "go all the way" as in HR2990 and return the "fed" to gov. control??
heck if you going "rogue" go all the way:
The authority to create money is a sovereign power vested in the Congress under Article I,5 Section 8 of the Constitution.
The enactment of the Federal Reserve Act in 1913 by Congress effectively delegated the sovereign power to create money, to the Federal Reserve system and private financial industry.
This ceding of Constitutional power has contributed materially to a multitude of monetary and financial afflictions, including: A growing and unreasonable concentra14
tion of wealth;
Unbridled expansion of national debt,both public and private;
Excessive reliance on taxation of citizens for raising public revenues;
Devaluation of the currency;
Drastic increases in the cost of publicinfrastructure investments;
Record levels of unemployment and underemployment; and
persistent erosion of the ability of Congress to exercise its Constitutional responsibility to provide resources for the general welfare of all the American people.
A debt-based monetary system, where money comes into existence primarily through private bank lending, can neither create, nor sustain, a stable economic environment, but has proven to be a source of chronic financial instability and frequent
crisis, as evidenced by the near collapse of the financial system in 2008.


BrizieMay 2nd, 2013 at 6:56 pm

Re: "..flooding the economy through Quantitative Easing will not cause inflation because, again, everyone wants liquidity and would rather hold it than spend it. In more normal times, budget deficits and money helicopters would cause inflation and rising interest rates. And that would be bad."
Does it matter from an inflation perspective who receives such large QE injections, and on what they are likely to spend/invest those dollars. e.g. If only super-rich bondholders reap QE injections, does that population's spending/investing pattern cause an inflation impact on specific parts of the economy which are or are not measured in inflation data collection?
Do inflation measurements include the spending patterns of the rich? Have the prices of yachts, fifth mansions and Monets experienced big inflation while the core-inflation market basket has experienced minimal change?
Do the inflation data collectors measure the spending patterns of the super rich?

L. Randall Wray L. Randall WrayMay 2nd, 2013 at 11:59 pm

Brizie: Yes good points. Indeed, the rich are usually the culprits for inflation. Not only do they have more money, and spend more, they also buy the stuff that contributes most to inflation. All that Gucci junk, you know, and Harvard educations (so they can rub noses and well, maybe ..unmentionable.. with Profs Rogoff and Reinhart). And much of it imported, too. And then they evade taxes by banking in the Bahamas; and blow up our financial sector. And on and on and on. You know the drill. And then they blame Burger King minimum wage workers for inflation.

BrizieMay 3rd, 2013 at 3:43 pm

So, are both the colorful crowd at Zero Hedge AND the Krugmans of the world BOTH right? Has massive inflation hit one part of the US economy, but not much of the part that gets measured in standard inflation statistics?

Have we witnessed great inflation in the things rich people buy, like $10 million Gerhard Richter paintings etc., as a result of monetizing a real estate bubble with QE? What inflation report disaggregates the spending of the rich? Substantially different or contradictory phenomena can be masked in aggregate data reports. Is the spending of the super rich actually in the aggregate statistics? Do the super rich allow data collectors to interview them about their spending habits?

Krugman keeps pointing out runaway core inflation has not materialized. But, do the rich buy more of the things measured in core inflation when they get their QE fix? If they add one more $500,000 car to their collection, is that measured in core inflation? Is their increased shopping in financial markets reflected in core inflation, other than say commodity price increases?