Reading Keynes at the Zero Lower Bound

The Berkeley Economic History Lab working paper series has recently put up a new paper by Richard Sutch, "The Liquidity Trap, the Great Depression, and Unconventional Policy: Reading Keynes at the Zero Lower Bound." From the abstract:

The developed economies of Japan, the United States, and the Eurozone are currently experiencing very low short-term rates, so low that they are considered to be at the “zero lower bound” of possibility. This effectively paralyzes conventional monetary policy. As a consequence, monetary authorities have turned to unconventional and controversial policies such as “Quantitative Easing,” “Maturity Extension,” and “Low for Long Forward Guidance.” John Maynard Keynes in The General Theory offered a rich analysis of the problems that appear at the zero lower bound and advocated the very same unconventional policies that are now being pursued. Keynes’s comments on these issues are rarely mentioned in the current discussions because the subsequent simplifications and the bowdlerization of his model obliterated this detail. It was only later that his characterization of a lower bound to interest rates would be dubbed a “Liquidity Trap.” This essay employs Keynes’s analysis to retell the economic history of the Great Depression in the United States. Keynes’s rationale for unconventional policies and his expectations of their effect remain surprisingly relevant today. I suggest that in both the Depression and the Great Recession the primary impact on interest rates was produced by lowering expectations about the future path of rates rather than by changing the risk premiums that attach to yields of different maturities. The long sustained period when short term rates were at the lower bound convinced investors that rates were likely to remain near zero for several more years. In both cases the treatment proved to be very slow to produce a significant response, requiring a sustained zero-rate policy for four years or longer.

Sutch notes that "the General Theory is a notoriously unreadable book, one that required others to interpret and popularize its message." Since Keynes did not use the phrase "liquidity trap"--it was coined by Dennis Robertson in 1940--interpreting Keynes' policy prescriptions in a liquidity trap is contentious. Sutch reinterprets the theory of the liquidity trap from the General Theory, then examines the impact of Federal Reserve and Treasury policies during the Great Depression in light of his interpretation.

Sutch outlines Keynes' three theoretical reasons why an effective floor to long-term interest rates might be encountered at the depth of a depression:

(1) Since the term structure of interest rates will rise with maturity when short-term rates are low, a point might be reached where continued open-market purchases of shortterm government debt would reduce the short-term rate to zero before producing a sufficient decline in the risk-free long-term rate [Keynes 1936: 201-204 and 233]. 

(2) It is, at least theoretically, possible that the demand for money (called “liquidity preference” by Keynes) could become “virtually absolute” at a sufficiently low longterm interest rate and, if so, then increases in the money supply would be absorbed completely by hoarding [Keynes 1936: 172 and 207-208]. 

(3) The default premiums included as a portion of the interest charged on business loans and on the return to corporate securities could become so great that it would prove impossible to bring down the long-term rate of interest relevant for business decisions even though the risk-free long-term rate was being reduced by monetary policy [Keynes 1936: 144-145].

The first two reasons, Sutch notes, are often conflated  because of a tendency in the post-Keynesian literature to drop short-term assets from the model. The third reason, called "lender's risk," is typically neglected in textbooks and empirical studies.

In Keynes' view, the Great Depression was triggered by a collapse in investment in 1929, prior to the Wall Street crash in the fall, as “experience was beginning to show that borrowers could not really hope to earn on new investment the rates which they had been paying” and “even if some new investment could earn these high rates, in the course of time all the best propositions had got taken up, and the cream was off the business.” Keynes maintained that a reduction in the long-term borrowing rate, to low levels would be required to stimulate investment after the collapse of the demand curve for investment. He suggested that the long-term borrowing rate has three components: (1) the pure expectations component, (2) the risk premium, and (3) the default premium.

Sutch goes on to interpret the zero lower bound episodes of 1932, April 1934-December 1936 and April 1938-December 1939 according to Keynes' theory. He concludes that the primary impact of unconventional monetary policy on interest rates was through lowering expectations about the future path of rates rather than by changing the risk premiums on yields of different maturities---but this impact was very slow. Sutch also concludes that a similar interpretation of recent unconventional monetary policy is appropriate. He notes four main similarities between the Great Depression and the Great Recession:

...the collapse of demand for new fixed investment, the role of the zero lower bound in hampering conventional monetary policy, the multi-year period of near-zero short term rates, and the protracted period of subnormal prosperity during the respective recoveries. A major difference between then and now is that in the current situation the monetary authorities are actively pursuing large-scale purchases of long-term government securities and mortgage-backed assets. This is the primary monetary policy that Keynes advocated for a depressed economy at the zero lower bound. This policy was not attempted during the Great Depression and it is unclear whether the backdoor QE engineered by the Treasury was an adequate substitute. 

While the current monetary activism is to be welcomed, Quantitative Easing then and now appears to be slow acting. In both regimes recovery came only after multiple painful years during which uncertainly damped optimism. Improvement came only after multiple years during which many lives were seriously marred by unemployment and many businesses experienced or were threatened with bankruptcy...Keynes opened his series of Chicago lectures in 1931 expressing the fear that, just possibly, "… when this crisis is looked back upon by the economic historian of the future it will be seen to mark one of the major turning-points. For it is a possibility that the duration of the slump may be much more prolonged than most people are expecting and that much will be changed, both in our ideas and in our methods, before we emerge. Not, of course, the duration of the acute phase of the slump, but that of the long, dragging conditions of semislump, or at least subnormal prosperity which may be expected to succeed the acute phase." [Keynes 1931: 344]

If you are interested in reading narrative evidence from Keynes' writing, the entire working paper is worth your time.