Tuesday, October 28, 2008

The Keynesian Liquidity Trap Trap

If the news reports are to be believed ("White House to banks: start lending money," Associated Press, 10/28/08) we may be seeing the first stages of a Keynesian "liquidity trap" similar to that which contributed immensely to the Great Depression.

According to Keynesian theory, a "liquidity trap" is when the interest rate approaches zero. Investors do not expect high returns, so they keep assets in short-term cash bank accounts or hoards rather than investing. This makes a recession worse, and can result in deflation, or an insufficient money supply.

The usual Keynesian remedy for stimulating the economy is to lower the interest rate — as the Federal Reserve has been doing. The other Keynesian approach is to increase the rate of inflation, which (because of the presumed tradeoff in Keynesian economics between unemployment and inflation) is not considered feasible at this time when the unemployment rate is increasing. The only hope, then, of avoiding the "liquidity trap" is for banks to lend for political rather than economic or financial reasons — regardless of the credit-worthiness of the borrower . . . which is precisely what got us into the current financial crisis in the first place.

The inevitable conclusion is that the situation is hopeless, regardless who is elected president. Both candidates are operating from within a Keynesian economic paradigm, and thus neither can offer anything other than a vague promise of "change." With Keynesian economics, however, the only change can be for the worse.

So, is there no hope at all? Not at all. Banks will not lend unless they can obtain adequate security for their loans — and if they don't have to worry about risking the savings of depositors. Security, however, can be provided by "capital credit insurance," as outlined in CESJ's Capital Homesteading proposal, while money can be created at will with 100% reserves by opening up the discount window of the Federal Reserve as originally intended in the Federal Reserve Act of 1913.

Thus, although Keynes assumed the contrary as an "iron law" of economics, it is not necessary to cut consumption in order to invest. Cutting consumption actually inhibits or prevents the financial feasibility of new capital formation, again making it less likely that banks will lend.

With all the wasted resources, excess capacity, and idle people in the economy, the only thing missing is a sound approach to money, credit, and banking. Money is a means to an end, not an end in itself, and should never be a barrier to full participation in the economic common good.

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