Sunday, 25 August 2013

Can Pigou Refute the (Keynesian) Liquidity Trap?

by Jaime Bravo + (A spanish version of this article can be found here)

Keynesian economists believes that, in the presence of a liquidity trap, a competitive economy may lack automatic market mechanisms that tend to eliminate excess supplies of labor. So, in a liquidity trap, if the interest-rates are so low, there must be some public spending in order to "rebuild" the economic activity. Although Keynes made great points on this issue, the classical economists have something to say. Here enters the Pigou Effect and its relation with the Liquidity Trap. As Paul Krugman said (not exactly quoted): there might be a moment for every economy when markets cannot do anything by themselves as the interest-rates are so low - it means that there is no investment in the country - and, as you can have less than a 0% - in a negative interest rate, the Government would have to pay the investors to invest - you have to make something. The answer for Keynesians is, yes, public spending. The logic behind this asseveration is surprisingly simple: a country - say, Spain - has a lot of people with money, but they do not invest it, they save it because, for example, there's high unemployment and a big uncertainty in the future - the risk of losing all the money is here.  If a Government expands its public spending, it will raise the number of jobs. Considering that Spain - the example taken - has a lot of unemployed people (which is actually true), they will be employed and therefore, they will be less resistant to spending. So debt will increase, yes. But the problem with the debt-obsession - I'm nowadays reading to Reinhart and Rogoff on this issue - is that it is not quite relevant sometimes: if you have 7 million unemployed in a country, debt doesn't matter: the high unemployment rate does.

If we consider the Pigou Effect - which means that a large fall in prices would stimulate an economy and create the 'wealth effect' that will generate full employment - it has a different vision on how to deal with unemployment and, therefore, with the long and the short-term of the economy. So first of all, what about debt? I'm one of these people who think that debt does matter, but just sometimes. Unemployment matters more. And, once we knew that Reinhart and Rogoff went wrong on their estimations (90% of public debt compared to GDP makes growth stop) we've more reasons to say that we need an alternative in the economics policies driven in Europe.  McCallum (1982, see references) wrote a simple equation related to Tobin's paper that does consider the liquidity trap as something true; something that really exists. Tobin was such a great economist. There has been some controversy with his speculative-tax though. Anyway, the vision he had about the liquidity trap was acceptable.

In fact, the relation between debt and the different economic schools is incredible. Now, focused reading in the book This Time is Different from R&R, I see what non-heterodox economists think about the debt. We still think that a country is like a company. So those who borrow and do not pay later - or pay but in a large range of time, for example, the credit that the IMF lends to a country, e.g. Thailand, they say, have the same characteristics than those who borrow and should pay. One of the most important lessons in economics, is to assume that families and countries musn't be driven under the same rules.

An Essay on the Liquidity Trap and Pigou 

Nick Rowe published a post on his blog about old Keynesians, new Keynesians, the liqudity trap and the Pigou Effect. There, he said that Keynesians need the Pigou Effect. I found the article very interesting, because Di Matteo makes up a debate between an old Keynesian and a new Keynesian and he concludes that, without the Pigou Effect, the models from the Keynesians won't work. But, is that true?

So looking at Figure 1 (Krugman) we can start to talk about the supposed efectiveness of the monetary policy. As Keynes argued, in recessions, the monetary policy is completely innefective. As Krugman says: at an interest rate near zero the demand for money must become more or less infinitely elastic, implying that the leftmost parts of the LM curve must actually be flat. And suppose that the IS curve happens to ontersect LM in that flat region, as it does in Fig. 1. Then changes in the money supply, which move LM back and forth, will have no effect on interest rates or output; monetary policy will be ineffective.

The real question is if we really need Pigou for our analysis and moreover, if Pigou was right about the liquidity trap. I don't think Pigou is COMPLETELY NECESSARY for our analysis. Yes, models can be wrong - and not just the keynesian ones, but orthodox ones too. It has been said that Pigou could avoid the liquidity trap as follows: unemployment rises which leads to a drop in the level prices which raises the real balance. Hence, consumption will rise and this will lead to a movemnt of the LM above the low interest rate, which will lead to full employment. This is how the Pigou Effect would refute the liquidity trap theory.

The problem is that it is well known by everyone that classical economists always assume full employment in their models. Keynes was worried about that, and so Keynesians economists were. Secondly, the Pigou Effect only will work with sticky prices. Thirdly, as pointed out by Wren- Lewis "[To make the Pigou Effect work] we have to assume that the nominal stock of money will remain unchanged, unaffected by falling prices" Kalecky also said (1944, see references) that it would increase the value of debts and led to a bankruptcy. Further to the last sentence, orthodox economists think that the markets correct their failures by themselves; they don't need help from other agents - i.e the State of a country X. Yet the Pigou Effect may be necessary sometimes in our economic analysis, as Di Mateo - and most classicals - argues. In any case, it deserves more research.


So the first question seems to be, no, Pigou cannot refute the Liquidity Trap. It can help in the models but it's not necessary per se. And, no, it does not get you out of a liquidity trap. As Wren Lewis said, even the Pigou effect is not a magic bullet that gets us out of a liquidity trap. Finally, the problem is that if prices fall today, they will increase tomorrow, which will not (really) make citizens feel wealthier and, at some instances, it will increase inequality - this is harder and I'll try to explain it a little bit here: let's say that the monetary authority keeps the stock of money constant and, as WL explains, falling prices means that its real value increases. But those who could afford, say, a car today, wouldn't be able to do it tomorrow. So those who saw their budget increase during, say, 4 years, would be poorer after the period ends, which would lead to a higher inequality in the income distribution. You may say - and it's completely reasonable - that if they have more money today, they have more chances to have more money tomorrow. And that might be true if you weren't under the -supposed- Pigou Effect. Here's, partially, why Kalecki said that it increases the value of debt; it does, and it also promotes inequality.

As inflation matters -it really does, but just sometimes- if people are wealthier today, it is just a virtual wealthy, because inflation will rise and they will have to pay for it. Finally, the important thing is if the stock of money is increased temporarily or permanently. If it's increased temporarily, it won't increase wealth, because being wealthier today means to be poorer tomorrow - because it's not real wealth but virtual wealth.




  1. Nick Rowe wrote that particular blogpost, not Livio di Matteo.

    1. wooops, my fault, thank you for that. Editing it right now.


Hi there!

We'd love it if you'd share your thoughts and ideas. Don't forget to check back after commenting because we try to reply to all of your comments.

Just remember to be nice, please!