Is Paul Krugman’s Liquidity Trap Really an Inequality Trap?

by Polly Cleveland | January 16, 2013

As I watched Paul Krugman Sunday night on Bill Moyers, I felt a familiar sense of despair. Krugman cares deeply about unemployment and inequality, as did John Maynard Keynes before him. Yet like Keynes, Krugman seems caught in the inequality-free neoclassical paradigm.

I study the “classical” economists, starting with Adam Smith. Inequality loomed large in their world. They divided society into three broad classes: First, the landlords: the original One Percent, the Downton Abbey crowd, the “great proprietors” of vast estates. Then the capitalists: the merchants and manufacturers. Last: the workers. The classical economists asked, what determines the distribution of income between these classes? But around the end of the 19th Century, the “neoclassical” paradigm swept in. Gone were the three social classes with dramatically different wealth and income. There were only consumers—from old Aunt Esther on Social Security to Donald Trump; producers—from Harry’s Shoes to General Motors; and government. Business cycles were best left to play themselves out.

During the Great Depression, to his credit, Keynes bucked his colleagues by claiming that government spending could revive a depressed economy. But, caught in the neoclassical paradigm, he got the mechanism wrong. Keynes argued, as does Krugman today, that the problem is a lack of consumer demand. Consumers want to save instead of spend. Lacking demand, businesses won’t invest. So there’s a “savings glut” or “liquidity trap”—billions in cash sloshing around seeking in vain for investment opportunities. The solution: government should borrow some of that loose cash and spend it, no matter on what: war, high-speed rail, fixing potholes, or education. Deficits be damned.

In my view, we don’t have a “liquidity trap”; we have an “inequality trap”. What’s that? An “inequality trap” happens in a downturn, when the One Percent, big corporations and banks hoard cash, starving small businesses for capital. The greater the inequality and deeper the downturn, the tighter the trap.

The multinationals are indeed awash in cash. In an article appropriately titled, “Dead Money” (11/01/12), The Economist reports how major corporations trim real investment—such as new technology—while piling up cash. For example, firms in the S&P 500 held about $900 billion in cash at the end of June, up 40% from 2008. The Economist dismisses the conservative claim that “meddlesome federal regulations and America’s high corporate-tax rate is locking up cash and depressing investment.” Why? All big multinational firms have been hoarding cash, not just US-based ones; it’s been a growing trend since the 1970’s.

The big banks are also awash in cash. For example, JP Morgan’s September 2012 balance sheet shows that out of $2,321 billion in assets, JP Morgan holds $887 billion in “Cash and Short-Term Investments”—over a third! (The “short-term investments” are gambles in the international money markets, but that’s a different story.)

To the One Percent, the cash bath may look like Krugman’s liquidity trap: a lack of investments yielding the high returns they enjoyed before the 2008 crash. But try telling small businesses there’s not enough demand and too much cash! They face drastic “credit rationing” by the banks. The banks are of course super-cautious these days, which is why they pile up cash. But in addition, the collapse in home values has reduced small business owners’ collateral for loans. And following the failure of many small banks and the consolidation of giant banks into megabanks, far fewer banks can or will lend to small businesses.

Today’s depression is a small business depression. Don’t forget, small businesses are the nation’s employers, providing far more jobs per dollar of assets or sales. According to Census data, in 2008, the 99.7% of US firms with fewer than 500 workers accounted for 49.4% of US employees. In 2007, comparing firms with under half a million in sales to those with over $100 million, the small firms averaged 15 employees per $100 million sales while the big ones averaged only three.

I respect and admire Paul Krugman for fighting the good fight. I just wish he would question the inequality-free neoclassical paradigm. An “inequality trap” requires different measures from a “liquidity trap.” It requires raising taxes on the One Percent and the big corporations—instead of borrowing from them and running up the deficit. It requires protecting ordinary workers and small businesses from the impact of payroll taxes like Social Security, for example by greatly increasing the earned income credit. In the short run, it requires avoiding capital-intensive spending like military or high-speed rail. Instead it requires extra spending to maintain education, health care, unemployment insurance and other urgent public services. In the long run, it requires enforcing anti-trust legislation and breaking up the big banks.

You are, of course, correct. FDR’s economic guru, depression expert, and Fed Chairman Mariner Eccles explained that the Great Depression was caused by certain economic players winning everything until the losers ran out of credit. No credit meant one was out of the economic game as a loser.

A commenter, Anonymous, has an excerpt from Eccles book too:

And deja vu:

  • Great work! This is very good way at looking at this issue. What would go in the model?

  • My congressman is an arch conservative who serves on the House Budget Committee with Paul Ryan. His economic solutions are quite opposite the analysis of this article. He’s been in government, mostly state level, for over 30 years and his argument has convinced this rural district’s voters, 61% voted for him. He claims so many strange or unsubstantiated facts it is difficult to keep up with his logic. Here’s a sample: “Indeed, as much as 87 percent of net small business income would be socked with these tax increases. To crush those businesses with an effective marginal tax increase of up to 13 percent and then expect them to create more jobs is simply insane.” I think he’s saying that raising the very top marginal tax rate on income exceeding $450,000 is insane. McClintock is his name, and this is from his 7 step program. As most know half of the Congress is filled with his ideological cohort. Their analysis of the economy is winning — more voters align with their arguments than with either Krugman or Ms. Cleveland. I wish someone would deconstruct his argument point by point to show the trash it is.

  • Most Americans lack six months’ savings – there is no “liquidity trap” – there is no liquidity!!! There is also very little in resemblance to a class system – and the divergence is really more a function of the money-printing than anything else (top 1% of the top 1% have enough money and market savvy to ride the Fed-induced bubbles, which inflate prices thus reducing purchasing power for everyone else). And the economy as a whole is not “hoarding cash” so much as hoarding government debt. Do you really want them to stop?

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