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Some simple economics

July 23rd, 2011 · No Comments

Huge “money printing” but no hyperinflation, hardly an uptick. Unprecedented budgetary deficits but very low interest rates and no crowding out of the private sector. How can this be explained?

The answer is, the good old liquidity trap:

July 22, 2011, 1:53 pm

This Age of Hicks

Matt Yglesias links to a libertarian blogger admitting some self-doubt after the failure of high inflation to materialize as predicted. I would offer a friendly word of caution to Mr. Lee: once he starts admitting the existence of contrary evidence, he’s on the road to becoming another Bruce Bartlett, who has become a moderate Democrat in all but name.

But let me use this as an occasion to make again a point I’ve made a number of times, this time slightly differently: what we’ve seen in the Lesser Depression is a spectacular vindication of one approach to macroeconomics, namely the modified Keynesianism of John Hicks. (Decent summary here.) What I and others have done on the liquidity trap can basically be viewed as elaborating and providing firmer foundations for the basic Hicks framework.

The real test of an economic model (or any model) is how it performs out of sample, that is, under conditions different from the usual. Hicksian theory makes two assertions that are very much at odds with what conventional wisdom suggests:

1. It says that once adverse demand shocks have pushed the economy into a liquidity trap, even very large increases in the monetary base — the sum of currency and bank reserves, which is what the Fed controls — will be basically sterile, leading neither to a boom nor to inflation.

2. It also says that under these conditions even large government borrowing will not crowd out private investment, and will not drive up interest rates.

So here’s a picture to illustrate the first point. It shows monetary base and nominal GDP since the recession began; if any kind of quantity theory applied, these should have gone up in tandem. Not quite:

Meanwhile, after several trillion of borrowing, the 10-year bond rate is a low, low 2.97%.

I can’t tell you how many times, in late 2008 or early 2009, I ran into people — including economists — who scoffed at the notion that either of the Hicksian predictions could really come true. They *knew* that inflation and sharply rising rates were coming any day now; and kept expecting them month after month.

So what we have here is, if anyone were willing to notice, a triumph of economic analysis.

Tags: Economics