It’s worth revisiting this issue in a world with $17 trillion in negative yield bonds.

Keynes was a complex thinker, who looked at issues from many different perspectives.  Unfortunately, that means his views were not always internally consistent. Thus it’s foolish to try to pin him down, as if sticking a pin in a butterfly. You’ll always find other passages that contradict your interpretation. Consider the following, from the General Theory:

There is the possibility…that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.

Some might say the message is clear, “Keynes said that liquidity traps don’t exist in the real world.”  But one can also find statements that go in the opposite direction, even on the same page.  Indeed two brilliant economists (Friedman and Hicks) both concluded that the liquidity trap concept was the driving force in the General Theory, the idea that underlay its important theoretical innovations.  So which is it?

Fortunately, we can examine the views of modern Keynesians, and this helps us to understand the seeming contradictions.  For instance, if you examine the blog posts written around 2008-09 by Paul Krugman  (who I’d argue is the Keynes of the 21st century) you see quite of few examples of each of these two basic claims:

1.  The Fed is almost out of ammunition, and we need fiscal stimulus.

2.  The Fed (and other central banks) could do more and should do more, even though it won’t be enough.

These statements aren’t actually contradictory, just a difference in emphasis.

This is from a famous December 1933 letter Keynes wrote to NYT:

The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.

Seems a pretty clear exposition of the “pushing on a string” concept.  So Keynes thought that open market operations were a waste of time, right?  This is from the same letter, right after he advocates public works projects as the first best option for recovery:

I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term Government Bonds to 2½ per cent or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.

Wait, so now open market purchases are one of the top two ways to promote recovery?  Notice that here Keynes makes a point of recommending that the US reduce long-term rates without printing money—presumably via some sort of “operation twist”, which replaces short-term bonds with long-term bonds on the Fed’s balance sheet. And if you read the rest of the December 1933 letter, it’s pretty clear why he opposes monetary stimulus—he thinks the dollar has already depreciated too much and is worried about “currency manipulation”.

Now we can see some differences between Keynes and modern Keynesians:

1.  Keynes believed the effective lower bound for long-term government bonds was about 2%; modern Keynesians correctly understand that long-term bond yields can go negative.  That’s actually a bigger deal than you might think, as it implies Keynes misdiagnosed the situation in the 1930s—central banks were not even close to being “out of ammo”.  That doesn’t mean I believe pushing long-term rates to zero would have helped all that much, but printing lots of money probably would have helped a great deal if it was being done with a freely floating dollar, and wasn’t being done merely to accommodate increased demand for bank reserves (as in the late 1930s).

2.  Some modern Keynesians, such as Joe Gagnon, do worry about currency manipulation.  But they explicitly exempt currency depreciation caused by QE done through the purchase of domestic securities, which is seen as a legitimate attempt to achieve the central bank’s macroeconomic target.

3.  Modern Keynesians would prefer that long-term rates be brought down with money creation, even if they doubted its effectiveness.  And if currency depreciation resulted, that would be seen as a feature, not a bug.  Barry Eichengreen (correctly) argued that an all out currency war during the 1930s would have helped to promote global recovery; it wasn’t a zero sum game.

Elsewhere I’ve argued that Herbert Hoover’s QE program of 1932 was largely ineffective due to the constraints of the international gold standard, not because of liquidity trap considerations.  Here it might be useful to remind readers that Keynes provided only one real world example of a liquidity trap in the General Theory:

The most striking examples of a complete breakdown of stability in the rate of interest, due to the liquidity function flattening out in one direction or the other, have occurred in very abnormal circumstances. . . .  in the United States at certain dates in 1932 there was a . . . financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms (pp. 207-08.)

Yes, that’s Hoover’s QE program, which occurred in the spring of 1932.  And it failed due to a gold outflow, not because interest rates could not be reduced.

To summarize, Keynes correctly predicted a world of ultra-low interest rates (albeit not this low).  But the details of his model were wrong, and it wasn’t until Krugman’s 1998 paper, “It’s Baaack . . . ” that the liquidity trap model was put on a solid theoretical foundation.  Keynes also gave FDR some bad advice in 1933, based on his faulty understanding of monetary policy.  Keynes was “reasoning from a price change”, assuming that ultra low long-term bond yields were good for the economy, however they were created, when what we actually needed was aggressive monetary stimulus, even if that raised long-term bond yields.  In Keynes’s mind, however, it was almost impossible for monetary stimulus to raise interest rates (outside of hyperinflation).

Nonetheless, Keynes’s letter is well worth reading.  Partly because it’s brilliantly written and partly because he has wise things to say about a wide variety of issues, ranging from politics to the NIRA to the difficulty of finding shovel-ready projects.