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The Myths of Financial Markets: Test #1: “Liquidity Trap”

The Liquidity Trap: Academic Envisioning or Imagination?

Brian E Hynes

Krugman, disagree or agree with his underling philosophy, has demonstrated he’s a dangerous person to follow for Market Advice. I call to caution as he is likely on the same level of the academic defrauder Mishkin. However, it is more fair at this point to simply illustrate lack of confrontation of his contradicting suppressed premises. Although that’s a very intellectually dishonest way to write; his fallacies are likely the result of his lack of knowledge between subjectivity and objectivity.

After much study of the prospect of a liquidity trap, objective logic presents a case resulting in a simple conclusion. It is beyond any objective doubt that its existence is nothing short of fiction. The liquidity trap is related to the transformation of definitions throughout the 1980s; Where falling prices; which undoubtedly is irrationally feared is completely inaccurate when a definiendum no longer matches its’ definiens; more simply stated as the mistaken definition of deflation “falling prices” rather than “contraction of the supply of money”. If you can understand that, not everything else is beyond the realm of comprehension in a deductively laid out argument. This objective method will give a very brief synopsis to analyze the validity behind the jargon:

A) Mr.Krugman defines a “liquidity trap” as “a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.” Furthermore, Samuelson and DeLong took insurmountable obstacles for the academics at the time; DeLong spoke of deflation as if it were the plague: “Thus there seems to be reason to be afraid of deflation. But there is no reason—at least not yet—to be very afraid.” He concludes that deflation should never be tolerated: “(T)he conclusion is obvious: good monetary policy should aim for a rate of change in the price level consistently on the high side of zero (Kaza 92).

The very theory itself at the most basic level is filled with contradictions that bear the greater study of a glaring flaw inherent in the premise. For instance, by the very central essence of “fearing” falling prices, we can presume with relative clarity that this infers there must be a direct if not causal relationship between “falling prices” and contraction of wealth. In other words, a measure such as CPI would illustrate this point. Nevertheless, that simply does not hold water. According to a study by Greg Kaza, the Bureau of Labor Statistics data blatantly contradicts this mistaken premise turned fallacy. Kaza illustrates that CPI was negative for 11 years from 1879-1895, which clearly shows that even in the most accelerated movements negative of the CPI in 1879 and 1895, the economy overwhelmingly experienced periods of expansion. Furthermore, the 20th century data demonstrates negative CPI in 1922, 1928, 1939 & 55. In each of those years, the data illustrates that each of those years consisted of 12 months (out of 12) of economic expansion in the face of the horror that is falling prices. The simple point of this data is such that even the most inflationary hawks must concede that their definition of deflation is not synonymous with economic and or contraction of wealth (Kaza 96). Thus, the inference that an economy cannot ever persist in an environment of falling prices is all but completely invalidated and void. The deductive logic I’m appealing to is that of objectivity; in NO way does this contort any misguided inference that ‘prices are beneficial’ or ‘have no relationship to economic contractions’, that would lead towards the traditional human fallacy that is known as false dilemma .

Instead, deductive reasoning leads you to investigate that deflation is not simply explained by a single sentence that can illuminate some clear relationship with economic growth. Some ‘falling prices’ are beneficial to the wealth of society while other goods ‘prices falling’ can have disastrous effects. Use your own logic; would it be beneficial for the wealth and prosperity of an economy if electronics, computers, and other technologies reversed the trend of the past thirty years; and LCD televisions, which originally retailed for $8000, were still technologically equivalent but never dropped in price? Of course, not, the televisions that retailed for that amount in 2001 are so technologically simple that you can purchase them for less than $80 today. The effect in actuality proves beneficial; as it forces producers to innovate new technological advancements in order to hold their profit margins steady.

Use the categorical imperative to begin comprehending the impact this has. Imagine a dream scenario of an entire economy that consists of nothing but this market of electronics, televisions, cell phones, and computers. Now presents the essential question; in this electronic based economy, is it justifiable to fear those prices falling? Would it be equally as prudent to use monetary policy to FIGHT and those price levels dropping in the economy? Would the economy be better off with the old bulky cell phones selling well north of $900? Your logic tells you obviously not; but now you are starting to think it would be foolish to treat the entire economy by the behavior of a single sector. Perhaps you can see how and why this can be damaging when you judge the whole from a part. Yes, that would be foolish to intervene on a market of technological firms to hold their prices higher. Deductive logic would lead you to the sub-inference that human interaction can have a damaging effect as well as beneficial; depending on the behavior of the sector in question.

Thus, it should be the objective consensus of all intellectually honest academics that falling prices in some sectors of the economy is beneficial for economic growth. This premise is consistent with the understanding and credence to the plausibility that falling prices can be consistent with a contractionary economy. Yet in balance, you have seen a plain illustration of the possibility that monetary stimulation or “forcing inflation” in some circumstances is counter-productive towards economic growth.

B) So what is the problem with the “Liquidity Trap”? Well, for the same reasons illustrated above. For some reason, everyone fears the “deflation” of 1990s Japan. However, what most people do not know? The fastest falling prices were the costs of raw goods, foods, and energy. Now, you do not need to enter exhaustive theoretical depth, just remember what prices are desirable to fall. The less expensive groceries, gasoline, metals, and raw materials for production drove the overwhelming market forces in Japan throughout the decade. Now, like stimulating a 9lb cell phone falling in price could cause detriments towards the wealth of the economy, pushing up food prices in the absence of rising wages for over 12 years, I argue, was as damaging as it was stimulating in the best case scenario. This is something that anyone can understand at the most fundamental level. It is important to determine sound premises to build advanced theories; otherwise issues that are as clear as this can be muddied into a “perfectly substituting” world.

Update 1/30: Response To a Critique

I’ve decided to post this response, keeping the last name of the author anonymous

Jose Sent the Following

We’re mixing supply and demand effects.

I think that liquidity trap, as defined by Keynes, is a situation where interest rates are so low that investors prefer to hold money (as an asset) instead of buying bonds, equities, shares or whatever. They fear that a fall in the price “of those assets” will produce capital looses that will more then offset the interests earned. Liquidity trap is bad because monetary policy becomes useless. Prices of goods have a very secondary roll here and it may reinforce the trap.

Deflation is bad. A general fall in prices is bad because loans are written in nominal terms. When demand is so weak that forces prices to fall firms that are already experiencing difficulties will have less and less money to pay back the money they borrowed to finance their investments. If prices go down sales will go down at least in nominal terms reducing firms cashflows.

Deflation is not the same thing as prices going down in a specific sector because productivity is increasing due, as in your example, to technological change. Technological improvements are good and prices going down is the way consumers benefit from those productivity gains. This takes place while sectoral output is growing and it is a good thing, supply driven, but has little to do with deflation, usually a fall in prices demand driven.

First, I am glad you questioned the definition, as that suppressed premise was not quoting Keynes, but the three NeoKeynesian individuals that I explicitly mentioned (Samuelson, DeLong & Krugman). I quoted Krugman explicitly for his definition of a Liquidity Trap but a suppressed premise definiendum was paraphrased quite accurately deriving from the Samuelson’s definition:

“The opposite of inflation is deflation, which occurs when the general level
of prices is falling.”


“A deflation occurs when prices decline
(which means that the rate of inflation is negative)”

So unless those are fake, we see that my paraphrase is not a distortion, and thus my criticism is just as it is valid.

Secondly, I do not see where we mixed up demand and supply. I was simply examining the suppressed premises behind the inference of falling prices and or a negative CPI (negative inflation) is inherently always a problem; both macro and micro examples were used to logically illustrate a plausible connection between the two. Perhaps you could elaborate further; because Samuelson’s textbook makes no distinction between the two (1948).
Third, your point on deflation being synonymous with “general fall in price levels” and then bad is an incomplete argument. Two points; your conclusion is based off two premises: one being loans being written in nominal terms, and second a weak demand perpetuates this problem. The suppressed premise that makes this argument complete would have to account for an explanation of “weak demand”; how did demand all of a sudden become “weak”. You imply that weak demand perpetuates a negative contraction of the money supply, which is plausible seeing as the contraction of available credit, without central bank interference; would lead an incentive for banks to seek to allocate additional capital from depositors by raising the rate of deposits. This of course would be a credit crunch. That is correct, but you forgot to mention cause of the sudden ‘weakening” of demand that inherently was followed by a credit crunch. Of course I can only speculate the causes; so lets look towards a fellow Keynesian; Robert Solow. It appears that a “weakening” of demand, even in his own models; is caused by over-consuming and under-saving in the present. So even by these standards. deductive logic leads us to inference that the credit crunch is a Consequence from prior actions, and implying that to be the cause is the classical form of a post hoc ergo propter hoc fallacy. Similarly; it’s similar to either a drug rehabilitation or a criminal going to prison for prior mistakes (The common premise is the penalty; ignoring the morality of the behaviors). To blame the penalty as the problem is fundamentally breaks down through the objective lenses of deductive logical analysis. Finally, I personally do not see the relevance of the cash flows because as you said, that would be in nominal terms; maybe the firm has increased its real value.

Fourth, I am not sure if you are inferring something different from I when speaking about the differentiation between sectors; because that was the entire point I was attempting to illustrate; so we are actually in agreement there, including your conclusion.
Fighting the symptoms won’t cure the disease. I agree that monetary policy has (I stress this) times where there are no Positive effects during some economic contractions; but logic tells you that this cycle has occurred repeatedly and has been eventually destroyed through the same method every single time: Replenishing savings, that’s why the fallacies surrounding this theory COULD be detrimental because they are discouraging savings at all costs. In doing so; there is quite a disconnect between prime rates and fed funds rates that may lead to some markets to, possibly, become increasingly vulnerable.

  1. 02/04/2012 at 4:27 pm

    Reblogged this on LVM Global Markets:.

  2. Michael Johnson
    02/17/2012 at 6:56 pm

    It seem Krugman has been pretty good at predicting the economy. Back in 2002 he claims the economy is weak and likely headed for a double-dip recession. Unless…

    “To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”

    And in 2005 he said there was a housing bubble that was beginning to pop.

    • 03/01/2012 at 11:57 am

      I have to state this again; I am not questioning professor Krugman’s ‘abilities’ per say; just the fact that he does not pursue intellectual integrity in his works. The result is blatantly horrible and or backwards advice being undertaken that seems more in line with a political motivation rather than objective, scientific, or intellectually honest.

      Just take the examples you provided: do you realize the sheer contradiction of “predicting”. Take the example you provided in 2002 first:

      2002: Aftermath of the 2002 “dot com” bubble bursting.
      Krugman’s proposal, Logical form:

      Premise 1). “Dot Com” bubble burst in 2001
      Premise 2) Recession that followed was caused by this bubble.
      Premise 3)(Supressed:) The economy was “stimulated” to delay a recession
      There is recession pressures
      Premise 4) The Federal Reserve stimulation merely delayed the ‘inevitable’ recession a short period.
      Premise 5) The bubble was irrational exuberance investing
      Premise 6) The solution for this is for the Federal Reserve to encourage irrational home investments and create a housing bubble

      Conclusion: Krugman actually proclaimed the bubble of irrational investments could be cured by artificially creating a BIGGER one. How anyone could follow and not doubletake on the irony is beyond anyone I know. Fix the bubble with the housing bubble… Hey I can take credit for calling the housing bubble… that I suspiciously clamored to be artificially manufactured by the federal reserve.

      Yeah, I would stay away from his advice.

  3. 02/29/2012 at 10:55 pm

    Excellent article, thanks.

  4. 03/01/2012 at 3:32 am

    Absolutely indited content material, Really enjoyed studying.

  5. Michael Johnson
    03/01/2012 at 1:21 pm

    That is not what Krugman was saying. He was saying that the economy is weak and likely headed back into recession unless Greenspan can create a housing bubble to make up for the lack of demand in the economy. I agree that he has gotten very political – because many in the GOP are playing politics with the economic facts and he is responding.

    For example, why did Greenspan keep rates at 1% until just a few months before the 2004 election? I thought at the time it was a mistake – as did most economists. There was even an Economist cover that said, “Mr. Greenspan Raise Rates Now”. I think republican Greenspan was trying to help republican Bush get reelected.

    In 1999 when the economy was in great shape (at least on the surface) and we had a surplus, Bush said we need a tax cut. In 2001 when the economy was in recession and we had a deficit, he said we need a tax cut. Ever since G.H.W. Bush lost in 1992, republicans have decided to always promise tax cuts because it helps their election chances.

    Right now, taxes are the lowest they’ve been in decades and the economy is the weakest it’s been since the depression and the GOP argues we need more tax cuts to improve the economy?!

    And don’t get me started on the idiotic Norquist Pledge!

    If the GOP would be honest and quit playing politics with the economy, I think Krugman wouldn’t be nearly as political. Hopefully after this election the GOP will give on taxes and the democrats will give on entitlement reform. Then we’ll see if I’m right about Krugman.

    • 03/01/2012 at 1:48 pm

      I’m not entering the realm of the falsity behind the left-right paradigm. I am not a Republican nor a Democrat nor is that relevant to objective proofs. I am objectively illustrating how he is intellectually deceiving his readers (See broken window fallacy for the best example). So I don’t take academic fraud as being justified because “Republicans” made him do it.

      Let’s take the logical standard form you claim he “did not say”. Can you explain which premise is invalid so I can re-evaluate the otherwise clear contradiction of his solution. I took all premises from his article and inserted the suppressed premise of what is self-evident.

      Bubbles are caused by Centralized Corporate Government planning. It seems Krugman knew this; and the creation of one to combat a different one is logically unsound and completely predictable final outcome.

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