By Henry Kaspar

One joy of blogging is that it provides an opportunity to present thoughts to a diverse, expert audience, and to see to whether the thoughts survive scrutiny. This post is different: I will ask readers for help with a puzzle that continues to bug me. The puzzle relates to the effectiveness of monetary policy in the liquidity trap.

There are two views on this issue, let’s call them the “traditional” and the “modern” view.

• The traditional view claims that in the liquidity trap monetary policy is powerless. If individuals want to hoard money rather than spend it, injecting more money won’t stimulate domestic demand. The most prominent proponent of the traditional view is of course Keynes. Among contemporary economists, this piece by Willem Buiter reads fairly traditional.
• The modern view has been developed by economists like Paul Krugman and Michael Woodford. It claims monetary policy can overcome the liquidity trap by creating inflation expectations that drive down real interest rates. If folks fear inflation would erode the real value of their cash holdings, this creates an incentive to stop hoarding. NGDP targeting builds on this, in essence it is a policy rule obliging the central bank to target higher inflation during depressions.

My trouble with the modern view is: how can the central bank create inflation expectations when the economy is stuck in the liquidity trap? 

True, the central bank can flood banks with base money. It has no means, however, to ensure that banks pass the impulse on to households and corporations through credit creation – which won’t happen as there is no demand. And even when the central bank circumvents the banking system and targets directly the real economy through asset purchases (QE), chances are that households and corporations will either hold the receipt of these purchases as cash, or deposit the receipts with banks, who in turn deposit them with the central bank. I.e., whatever liquidity is injected comes straight back to the originator. With no means of reflating the real economy, however, the central bank cannot stimulate demand. And with no means to stimulate demand, it cannot create a shortage of goods and therefore inflation.
[P.S.: for the latter the central bank would need to buy goods rather than assets, i.e., conduct fiscal policy].

If the central bank cannot create inflation, and markets understand this, how could the central bank create inflation expectations? To use a game theoretic term, announcing a higher inflation target to combat the liquidity trap looks like a non-credible threat.

In short, I suspect the modern argument has a whiff of circularity: it assumes that (folks believe) monetary policy can overcome the liquidity trap, and from there derives that monetary policy can overcome the liquidity trap.

I know of three counter-arguments, but neither leaves me fully convinced:

1. At some point the liquidity trap will end by itself, and the central bank will regain traction. If the central bank promises higher inflation for then, this would reduce real rates already now, and thus help the economy out of depression.  This link looks plausible but weak. Consider an economy like the U.S. that goes through a protracted balance sheet recession: credit constrained borrowers pay down excessive debts, transferring funds to creditors who have a higher propensity to save. Until debt is paid down to sustainable levels, private sector demand will be depressed – a process that can take years. The central bank could therefore promise higher inflation only for years down the road, changing savers’ calculus at best for very long-term investments – which, in turn, would arguably trigger a minimal increase in demand only, insufficient to eliminate the excess in desired savings. Cash hoarding would remain prevalent.
[P.S.: this concern is independent from the question of whether announcing a higher long-term inflation target would be time consistent and therefore credible]

2. The central bank could tie its currency to a foreign currency at a depreciated – and therefore inflationary – exchange rate. This is the Svensson mechanism. Essentially the central bank, unable do anchor inflation expectations itself,  would temporarily adopt a foreign anchor. I see how this could work for a small, open economy – but not for large, relatively closed economies like the U.S. or the euro area. The required devaluation would be huge, and the countries whose currencies were supposed to appreciate against the dollar or the euro would not allow this to happen.   

3. QE works not only through inflation expectations but also other channels, such as portfolio reallocation. I have no problem with the substance of this argument; one may label this Bernanke-QE as opposed to Woodford-QE. Yes, Bernanke-QE can work.  But it is a different matter altogether: portfolio reallocation aims at reducing longer-term interest rates, and an economy with positive nominal longer-term rates is not truly in a liquidity trap.

Our commentator Alex F. once noted that macroeconomists can be divided into mechanics and metaphysicists (similarly Nick Rowe). Metaphysicists trust the power of expectations, mechanics need a physical transmission channel. He is right. I am a mechanic. I won’t believe into the success of a policy as long as I fail to understand how it works. And if there are more folks like me out there, fighting the liquidity trap through inflation targeting is doomed.

But I sense I am missing something obvious. Who can help?