Liquidity Traps: Refuting the Irrefutable

In a recent article at Cato Unbound, titled Tim Congdon on Liquidity Traps vs. Portfolio Rebalancing, Robert Hetzel says: (emphasis mine)

If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

Hetzel is trying to demonstrate that the Federal Reserve can still influence aggregate demand even when the interest rate is against the lower bound (0%). Unfortunately, his irrefutable, logical conclusion is actually quite refutable and illogical. In Hetzel’s theoretical world, individuals willingly part with all of their assets (food, clothes, shelter, etc) in order to receive non-interest-bearing money from the government. Since the central bank owns all of the assets, individuals are then forced to purchase goods back from the central bank. (An aside: How does the central bank choose the price to charge?) While this certainly does stimulate expenditure, since individuals could not otherwise survive, history and logic suggest this moment could never arise. Using the same basic premise, here is a different possible conclusion:

A central bank decides to engage in unlimited open-market purchases. After parting with many/most of their assets, individuals realize that without food (assets) they will be unable to survive. These individuals resist exchanging their remaining sustenance for non-interest-bearing money. Working backward from that endpoint, individuals will begin to hoard physical assets. As other individuals try to purchase goods with money, the money price of assets will rise dramatically (money is devalued). The central bank’s actions will stimulate expenditure until individuals are no longer willing to accept money as a means of exchange.

Although both examples initially result in increasing expenditures, the second example is far from desirable for any economy. Based on this more realistic conclusion, some level of open-market purchases will likely pressure individuals to refrain from participating in the exchanges. An unlimited amount would therefore completely undermine the value of non-interest-bearing money.

To be clear, I am not suggesting that open-market purchases are inherently bad. My example simply makes clear that open-market purchases may have stimulative effects on short term expenditures, but longer-term costs that far exceed those benefits. As the great Frédéric Bastiat noted many years ago: (emphasis mine)

In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause--it is seen. The others unfold in succession--they are not seen: it is well for us if they are foreseen. Between a good and a bad economist this constitutes the whole difference--the one takes account of the visible effect; the other takes account both of the effects which are seen and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil.

Bastiat, Frédéric (2005-05-31). Essays on Political Economy (Kindle Locations 485-491).