Morning Must-Read: Richard Sutch: The Liquidity Trap, the Great Depression, and Unconventional Policy

Richard Sutch: The Liquidity Trap, the Great Depression, and Unconventional Policy: “John Maynard Keynes in The General Theory…

…offered a rich analysis of the problems that appear at the zero lower bound and advocated the very same unconventional policies that are now being pursued. Keynes’s comments on these issues are rarely mentioned… because the subsequent simplifications and the bowdlerization of his model obliterated this detail…. This essay employs Keynes’s analysis to retell the economic history of the Great Depression in the United States. Keynes’s rationale for unconventional policies and his expectations of their effect remain surprisingly relevant today. I suggest that in both the Depression and the Great Recession the primary impact on interest rates was produced by lowering expectations about the future path of rates rather than by changing the risk premiums that attach to yields of different maturities. The long sustained period when short term rates were at the lower bound convinced investors that rates were likely to remain near zero for several more years. In both cases the treatment proved to be very slow to produce a significant response, requiring a sustained zero-rate policy for four years or longer.