Paul Krugman and the Liquidity Trap Fallacy

There are literally countless texts on the necessity of government intervention into the economy. Paul Krugman, nobel-prize winning economist has been advocating that the Federal Reserve adapt a higher inflation target than what he refers to as the 2% orthodoxy, referring of course to the central bank’s inflation target of 2%. Paul Krugman writes:

“The point is that the conventional 2 percent target is a prejudice, nothing more; it once rested to some extent on studies suggesting that 2 percent was enough to make the zero lower bound a non-problem, but we now know how utterly wrong that view was; so we’re left with a target that’s considered respectable because it’s what all the respectable people say, and is what all the respectable people say because it’s considered respectable.

What do we want? Four percent! When do we want it? Now!”

Forgetting the obvious problems with the CPI not reflecting the actual rate of inflation for a moment, there is also a serious risk for the Keynesian Liquidity Trap.

As Keynes himself wrote;

There is the possibility … that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

The sheer irony regarding the above quote from Keynes is that, assuming it is completely true as stated, it utterly disproves Keynesian aggregate demand theory, and it completely destroys the basis by which Paul Krugman and other Keynesian economists have to justify government stimulus programs. For starters, Keynesian macroeconomics requires the general public to hold bonds of debt at some point or another. If lowering the interest rate too low creates a situation (as Keynes himself conceded) whereby people prefer cash to bonds, and thus doesn’t create any new (or sufficient enough) spending, then the obvious deduction to be drawn from this is that the lowering of the interest rate in order to stimulate aggregate demand was a bad idea to begin with.

This is just one more inconsistency with the Keynesian position.


Posted on May 25, 2013, in Economics and tagged , . Bookmark the permalink. Leave a comment.

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