Trapped in a Liquidity Trap
Jude Wanniski
July 13, 1999


Memo To: Louis Uchitelle, NYTimes
From: Jude Wanniski
Re: Reviving an Obsolete Idea

I have to hand it to you, Louis. You are the best financial writer in the country assigned to writing about obsolete ideas and the arguments among the economists who hold them. Several centuries ago, the NYTimes would have had you covering the disputes among the Ptolemaic astronomers. It only is dispiriting to me that since the death of Leonard Silk, there has been almost no interest in the Times in getting the views of the supply-side Copernicans, who believe the economic world revolves around the producer of goods, not the consumer of goods. I read with great interest your report on the Friday, July 2 business page, "Reviving the Economics of Fear," all about the "liquidity trap," a Keynesian idea that was developed in the 1930s. As you put it: "It means that the demand for goods and services consistently falls short of a nation's capacity to produce them, despite short-term interest rates as low as zero."

Keynes, of course, was forced to develop the idea of a "liquidity trap" to explain why his other theories were not working in practice. When great physicians insist your health will improve when you take their pill, and you soon expire, they must quickly develop a theory on why there is an exception to the rule. In the 1930s, Keynes developed the theory that producers were ready to produce but people didn't have money, so the government should give it to them, after either taxing it away from people who weren't spending it fast enough, or by borrowing it from the rich and giving it to the poor, who would spend it. Alas, all this was tried, interest rates approached zero because more people wanted to lend than wanted to borrow and spend, and the Great Depression only got deeper. The "liquidity trap" was the idea that held Keynesians together until World War II, when the government ran enormous deficits to buy things that were destroyed so rapidly after they were detonated or crashed or hit by enemy fire, that they had to be replaced.

In recent years, Keynesians changed their name to neo-Keynesians, because they observed that people were spending faster than they were saving, and we had the opposite of a liquidity trap (which they stopped talking about, except in hushed tones when you were around with a notebook). But now comes Japan, in its elliptical orbit around the consumer, with government deficits as big as World War II and interest rates shaving zero percent, and consumers are not only refusing to spend, but are becoming unemployed in greater numbers. In your report, you tell us that MIT Professor Paul Krugman -- one of the most revered economists in the Ptolemaic system -- actually traveled to Japan last year to see some consumers first hand. As you wrote: "He constructed a mathematical model, a standard tool of modern economics, to demonstrate that printing more money and lowering interest rates, even down to zero, would succeed in stimulating demand and expanding the economy. ‘Instead, I succeeded in proving to myself that this was not necessarily true,' he said. He concluded that a liquidity trap was possible after all. It was no longer just a historical curiosity -- a fading memory of the Depression and the teachings of Keynes. It had happened in Japan."

WoW!! GollyGeeWhillikers!! The Great Krugman constructed a mathematical model and actually went to Japan to discover that it did not work, so he must have run into the same liquidity trap that Keynes discovered 60 years ago to explain why his theories did not work. Lou, does this mean Japan has to have a war in order to get out of its liquidity trap?

I apologize if it seems to you that I might be smiling to myself over all this, but the Times does not have any funnies, so I have to get my laughs where I can. There is no such thing as a liquidity trap, Lou. In the supply model, monetary policy in a country is too tight not when interest rates are high, as Krugman surmises, but when the price of gold is falling because of too little liquidity. Japan needs to forget about interest rates, cut the capital gains tax on real property, and target a gold price of at least ¥40,000 to the ounce (where it is now closer to ¥30,000). It would work in practice as good as in theory!

Do you know what the intellectual problem is, Lou? The economics establishment refuses to recognize my 1977 discovery that the Crash on Wall Street in 1929 was caused by the surprise of the Smoot-Hawley Tariff Act, which was signed into law by Hoover in June 1930, but whose passage was foretold in the U.S. Senate votes of October 1929. Unable to explain the Crash in a supply framework, John Maynard Keynes cooked up the idea that prior to the 1930s the producer was at the center of the system, but now the consumer was in control. Do you know, Lou, that 22 years after I first published my hypothesis in The Wall Street Journal, and 21 years after I documented my findings in my book, The Way the World Works, that nobody on the staff at the NYTimes has ever been allowed to write about it. Even Leonard Silk, who was good enough to call me now and then in an attempt to figure out why supply-side economics was so popular with the voters when it wasn't supposed to work, never connected the Crash with my Supply Shock.

Once you understand the supply model, Lou, you can go anywhere in the world, even Japan, and fairly quickly figure out why producers are not exchanging with each other as rapidly as they could be. (There are no consumers in a supply model, Lou, only people who make bread exchanging their surplus with people who make wine.) Years ago, I explained to my clients at Polyconomics that Japan would never conquer the world, because it had a legion of young economists who had trained at Harvard, Yale, Stanford and MIT coming of bureaucratic age. They would destroy the Japanese economy by mismanaging the economy along Keynesian, neo-Keynesian and monetarist demand-side principles. When the stock market "bubble" burst in 1990, I finally discovered that the effective capital gains tax on real property had risen sharply on Jan. 1 of that fateful year. The risks of people financing the exchange of bread and wine and everything else in the system had suddenly shot up, which meant the value of financial assets went down. I've explained this many times to Timesmen, but it is politically incorrect at the Times to blame anything bad on a higher capital gains tax or to credit anything good on a lower capital gains tax. Your simple rule of thumb, I take it, is to credit the Keynesians when their theories work in practice and to excuse them when their theories fail, because of liquidity traps. It is about 50-50, no?

One of these days, Lou, you should ask your editors if it would be okay to ask a variety of Ph.D. economists to read Chapter VII of my book, about the Crash, and have them go on record with their comments. Unless and until it becomes politically correct at the Times to admit I got it right, I'm afraid you will continue to be trapped in liquidity traps.