Kantian Reflection on Macroeconomics

By Pira Saravanamuthu

Kantian Reflections on Macroeconomics

10th December 2012

Economic downturns are common. However, economic downturns caused by systemic banking failure are rare. Economic downturns caused by banking failures result in a particular form of economic downturns called “liquidity traps”.

A short history of liquidity traps

The key feature of a liquidity trap is that the central bank is not able to end the economic downturn by lowering short-term interest rates. Lowering the short-term interest rate is the same thing as the central bank temporarily increasing the money supply. Usually, the central bank is able to end most economic downturns by temporarily increasing money supply and thus restore the velocity of money.

Paul Samuelson was the most gifted economist of the 20th century. He has written one of the best explanations of what happens in a liquidity

trap. This is what he wrote in his classic Economics textbook in 1948:

“‘You can lead a horse to water, but you can’t make him drink.’ You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.”

Paul Samuelson had to come to this conclusion after studying the Great Depression very carefully. When Japan entered its liquidity trap in the 1990s, its experience confirmed Samuelson's description.

During Japan’s liquidity trap in the 1990s, the Bank of Japan massively increased the money supply, for a temporary period of time, in a desperate attempt to get out of the liquidity trap. (Please see blue line in the graph below). However the velocity of money as represented by the red line stayed the same:

Source: Bank of Japan

This happened because all of the increase in increase in the money supply stayed in Japanese bank reserves and was not actually spent on buying real goods and services. This occurred because the Japanese

banks were insolvent. As a result, the insolvent banks were hording money rather than lending it out. In order the restore the velocity of money people and institutions must be made solvent again.

During a liquidity trap, restoring the velocity of money is key to restoring economic normality. This can be done by one of the following:

1. Governments increasing spending on real goods and services2. The central bank permanently increasing the money supply

Economists failed to understand the liquidity trap

Unfortunately, during this economic downturn, almost all European and American state governments sharply cut government spending. Although the American Federal government implemented a modest spending package – this was largely undone by the 50 American states cutting government spending simultaneously. This explains the anaemic recovery on both sides of the Atlantic.

Many people are now slowly coming around to the belief that cutting government spending during a liquidity trap is a bad idea. They are coming around to this realisation after many of Europe's economies have been impoverished by austerity. The question is why it took us so long to get to this realization – since it was abundantly clear right from the beginning, that a systemic banking failure was the cause of the current economic crisis? Why did so many public officials and academic economists fail to appreciate the significance of a liquidity trap?

After all previous generations had described the liquidity trap very well. And those economists that had studied Japan in the 1990s (like Paul Krugman) confirmed the earlier wisdom about liquidity traps.

Experience is critical to knowledge formation

It turns out that most academic economists and public officials did not appreciate the significance of the liquidity trap because they had not lived through it. The liquidity trap was obvious to Paul Samuelson and his contemporaries because they had lived through the Great Depression, which was essentially a massive liquidity trap.

The liquidity trap was obvious to Paul Krugman because he spent a lot of time studying Japan and thinking about their low-grade depression in the 1990s. As it were he experienced the liquidity trap. Not only did Paul Krugman experience the liquidity trap, he also spent a lot of time thinking about the liquidity trap. This put him in a good position to understand what was going on.

However, the other economists who held major professorships in America and Europe did not understand the liquidity trap because they had not lived through a liquidity trap themselves. And it turns out that reading about previous liquidity traps cannot get you to understand a liquidity trap.

All of this takes us back to Immanuel Kant's insight on how we form knowledge:

“All our knowledge begins with the senses, proceeds then to the understanding, and ends with reason. There is nothing higher than reason.”

And he goes on to say that:

“It is beyond a doubt that all our knowledge that begins with experience.”

Paul Krugman was able to make the intellectual breakthrough because he had experienced the liquidity trap - which is a once in every three generations phenomena.

Almost all the other economists ignored the Japanese experience in the 1990s because they thought the Japanese depression arose out Japan's peculiar political and economic set up. The Economist followed events in Japan closely. However, like most American and European thinkers, they too blamed Japanese political and economic culture for the economic malaise. Here is The Economist magazine summaring who was to blame for Japan's economic malaise on 16th February 2002:

Vested interests—among the bureaucracy, the politicians of the ruling Liberal Democratic Party (LDP) and the disproportionately powerful voting blocks that back it—are clearly the prime culprits. These groups benefit in some ways from Japan's malaise, especially from the fiscal gravy train that has rattled along unhindered throughout the slump. Just as important, these factions are perennially battling each other, over which of them should bear the shame and financial costs of fixing the problem.

And so, economists in Europe and America dismissed the Japanese experience in the 1990s as being peculiar to Japanese culture. Most economists in Europe and America did not think of it primarily as an economic problem. They also dismissed the Great Depression as a one off historical oddity with no direct relevance to them.

Lawrence Summers was the chair of Harvard’s Economics department until he went to work for President Obama’s administration as senior economist in 2009. When he returned to Harvard in 2011, he reflected on the frameworks that had helped him the most to deal with the financial crisis. He said the most useful frameworks came from economists a century ago. He also said that the latest economics research was not at all helpful:

“There is a lot in Bagehot [1873] that is a lot about the crisis that we just went through. There is more in Minsky [1975] and perhaps still more in Kindleburger [1973].

“[But] there is enormous amounts that is essentially distracting,

confusing and problem denying in the stuff that is the substance of the first year course in most PhD programs.

“So I think economics knows a fair amount. I think economics has forgotten a fair amount that is relevant. And it has been distracted by an enormous amount.

“It is my impression that it would be quite easy to graduate with a PhD in economics from many prominent economics departments in this country with only the vaguest notion of what the liquidity trap is – whilst at the same time being familiar with the substantial amount of subtlety surrounding dynamics stochastic equilibrium.”

Brad DeLong is chair of Economic History at University of California, Berkley. He has explained that in academic institutions it is easy to get carried away with theory and ignore reality. In his address to the Annual Conference of American Economic Historians in September 2007, Brad Delong explained that this approach can be unwise and dangerous:

"In economics departments I hear that it's unfair to spend so much time studying history when there are the crying needs for more theory.

“And when I hear this I want to respond: what do you think theory is? Theory is, after all, nothing but distilled history, processed history, freebase or crack history--you know, it reaches the brain and alters your neurotransmitter balance in five seconds. But freebase and crack or very dangerous: better to simply chew the leaves.

“As Alan Greenspan said on Friday night, to gain insight into the state of financial markets today you would have been much better advised to do a narrative and institutional study of the panic of 1907, or the "Turlip Bubble," than building a statistical model or applying Ito's lemma to the no-arbitrage condition."

Or as Immanuel Kant put it:

“Theory without experience is mere intellectual play.”