Must-Read: Cullen Roche: Does a “Liquidity Trap” Ever End?

Must-Read: Cullen Roche: Does a “Liquidity Trap” Ever End?: “Brad Delong has a very smart post over at Equitable Growth…

…discussing the recent Feldstein commentary on inflation as well as Paul Krugman’s Liquidity Trap model of the current economic environment. Brad, unlike Paul, is not so quick to assert that the Hicksian model that Dr. Krugman has been using, is a big success.  He says:

The problem is that the macroeconomics that Paul Krugman learned at Jim Tobin’s knee wasn’t just 1930s-style Hicks-Hansen Keynesianism. It was the 1970s adaptive-expectations Phillips Curve neoclassical synthesis–nearly the same stuff that I first learned at Marty Feldstein and Olivier Blanchard’s knees in the spring of 1980. That is the framework that Marty is using know, and that generates his puzzlement. That framework had a short run of 1-2 years, a medium-run transition-dynamics phase of 2-5 years, and a long run of 5 years or more baked into it. You cannot–or at least I cannot–just throw away the medium run transition dynamics* and the declaration that the long run Omega Point is five years out, and say that mainstream economics does well.

Another way of saying this is that we’ve supposedly had a ‘Liquidity Trap’ in Japan for several decades and now we’re starting to get very long in the tooth in the ‘Liquidity Trap’ in the USA.  Given the apparent permanence of this environment we have to wonder at what point we begin to question whether we’re in a ‘Liquidity Trap’ at all. Or, were we never in a Liquidity Trap?

To be clear, a Liquidity Trap, according to Paul Krugman, is when conventional monetary policy (changing interest rates) doesn’t work. This isn’t the old Keynesian definition, but who cares because Paul isn’t using a Keynesian model anyhow (Keynes flatly rejected the Natural Rate of Interest that is so central to Krugman’s theory).

So, with the USA now into year 7 in its Liquidity Trap we have to wonder – is traditional monetary policy permanently broken?  Is it going to become ‘normal’ some time soon? If so, when? OR, could it be that traditional monetary policy was never quite as powerful as we thought which means that its recent lack of efficacy is nothing abnormal at all?

That last question is particularly interesting because it would mean that models like Paul Krugman’s Hicksian model, which are based on the Natural Rate of Interest, are a lot less useful than one thinks.  And that would mean that New Keynesian economics has much bigger holes in it than some of its adherents believe. Most importantly, it means that Paul Krugman hasn’t been right for the right reasons. It means he has been right for the wrong reasons.