Falling into the liquidity trap: Notes on the global economic crisis

Falling into the liquidity trap: Notes on the global economic crisis by Thomas R. Michl This paper examines the underlying structural imbalances leading up to the Great Recession of 2007-2009 from the vantage point of Hyman Minsky’s theory of the liquidity trap. The traditional approach to the liquidity trap focuses on the zero interest rate boundary while Minsky’s theory focuses on three conditions that make investment spending unresponsive to monetary policy: low underlying ex post profitability of capital, weak expectations about future profitability, and uncertainty about prospective yields. The paper structures an empirical investigation of profitability and accumulation around these three factors. The Great Recession was preceded by an unbalanced recovery in which residential investment led demand while business fixed investment was structurally weak, given the strong ex post profitability of capital and the low interest rate environment. It is hypothesized that increased import penetration and concerns about the sustainability of profitability eroded both expectations and confidence about prospective yields. The Great Recession appears in this and several other dimensions to be a crisis of disproportionality. Today and presumably for the future the schedule of the marginal efficiency of capital is, for a variety of reasons, much lower than it was in the nineteenth century. The acuteness and the peculiarity of our contemporary problem arises, therefore, out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money. —John Maynard Keynes (1964 [1936], pp. 308-309) 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 control over the rate of interest. But whilst this limiting case might become practically important in the future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. —John Maynard Keynes (Op. cit., p. 207) According to the Economist (2009) magazine, on January 8, 2009 the official policy rate set by the Bank of England reached the lowest level since its founding in 1694. The U.S. Federal Reserve Board lowered its policy rate to a range of zero to twenty-five basis points in December 2008. And both the Bank of England and the Fed have initiated unprecedented programs of buying long-term financial instruments. The “test” to which Keynes refers in the second epigraph has arrived, and whether this will be the limiting case now generally known as a liquidity trap is sure to be the subject of academic debate and discussion for years to come. This paper attempts to provide some analytical and empirical perspective on the financial and economic crisis that began in the U.S. in late 2007 and that now envelops the global economic system. It proceeds from the observation made by Keynes in the first epigraph. The precondition for descent into a liquidity trap lies in the real conditions that govern business investment, and in particular, in the profitability of capital (which is what Keynes means by the marginal efficiency of capital). The financial aspects of the current crisis have gotten plenty of attention from writers better qualified