Money Week, Part III

If you had to name ONE defining characteristic of the revolution in economics scholarship known as Keynesianism: what would it be? 

Probably this: Keynes offered a distinctive explanation of sharp economic downturns within capitalist systems -- call them crises, depressions, recessions, or whathaveyous. Keynes explained them in a way that suggested a toolbox of remedies. His book, The General Theory, was published in 1936, so you would expect it to have something to say about that subject.  

What is distinctive about his theory is that although it involves the price of borrowing money (i.e. interest rates) it does NOT directly entail monetary policy. His tool box does not include things like "mint silver." Indeed, this may be considered odd because his is the first significant book in the history of economics to appear AFTER the overthrow of the long dominant role of gold either as money or as a backer of money.  Yet he put that issue on the shelf.

Instead, Keynes produced a theory often summarized in the expression "the liquidity trap." This refers to a situation in which interest rates have become so low that the preference for cash is nearly universal. Everybody becomes a hoarder. 

There was always something counter-intuitive about this. Low interest rates 'should' be a spur to economic growth. If I can borrow money at or near 0%, I will likely do so, both as a consumer and as an entrepreneur, and from either end the cheaply borrowed money will stimulate the economy. Right? well ... maybe. 

But a 0% [or 0.1%] rate of interest doesn't necessarily mean I'll be able to borrow money cheaply for either purpose, consumption or business-building. It just means that IF I can borrow money, it will be costless or very cheap to do so. But somebody still has to be willing to lend it to me. Such a low rate may mean that no one is willing. The quantity of money borrowed is definitionally identical to the quantity of money lent! So if everyone is hoarding, no one is getting this cheap money. 

Keynes' talk of a liquidity trap was instigated largely by those infamous bank runs of the early depression years. Banks couldn't lend money at those cheap rates unless they could stay in business, and they couldn't do that if all their depositors decided the cash would be better off in their mattress! No deposits, not functioning banks, no cheap loans, no stimulative consequences. 

Thus the "liquidity trap" and the toolbox for addressing it, including everything from deposit insurance to the insurance of other private sector risks to outright government stimulus spending. I'll say more about this subject shortly.

But this concludes our Money Week. Thank you for reading.