14 Aug 2009

On the Other Hand: A Sample of Brad DeLong

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Every once in a while it occurs to me that it’s possible my worldview has a serious flaw in it, and that the people who really drive me through the roof might actually be right. Fortunately, such moments soon pass and I can get back to blogging.

But just to make sure you guys realize that our opponents aren’t morons, let me quote from a recent Brad DeLong essay in which he discusses the thought of John Hicks. After explaining the conventional mechanism through which central bank operations can stimulate an economy, DeLong says:

A little thought, however, will lead us to the conclusion that such open-market operations may fail. In them, the Federal Reserve is buying bonds, shrinking the supply of bonds out there–and thus pushing up their price and pushing down interest rates. For each amount that the Federal Reserve expands the money stock, therefore, it puts downward pressure on interest rates and thus on monetary velocity. In the limit where interest rates are so low that people don’t really see a difference between cash and short-term government bonds like Treasury bills, open-market operations have no effect because they simply swap one zero-yielding government asset for another.

It is in this situation that a government deficit can be useful. A government deficit means that the government is printing and issuing a lot of bonds at exactly the same moment that private investors are looking for a safe asset to hold. As these bonds hit the market, people who otherwise would have socked their money away in cash–thus diminishing monetary velocity and slowing spending–buy the bonds instead. A large and timely government deficit thus short-circuits the adjustment mechanism, and avoids the collapse in monetary velocity that was the source of all the trouble.

Lately I have come to believe that the notorious “liquidity trap” is a legitimate phenomenon. The closer nominal interest rates approach zero, the more that government debt begins to resemble government fiat money. This surely can’t be a good thing.

Think of it: The central government and central bank conspire to take the distinct markets of debt and money, and merge them into a common reality. It’s like they divided by zero.

Naturally, I’m not endorsing the Keynesian policy prescriptions for “what to do when you’re in a liquidity trap.” But I’m saying that Keynesians have been saying for more than a year that something funky happens when central banks drive interest rates down to zero. And unfortunately, their Chicago School / monetarist critics have largely ignored their insights.

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