In my last post, I alluded to an austerity trap, analogous to the liquidity trap. This reminded me of something. People often associate the liquidity trap with the zero lower bound on interest rates. But as people so often say, Keynes wasn’t as Keynesian as all that. He was very much interested in expectations, uncertainty, and the psychological dimension of economics.
The liquidity trap happens not just because interest rates can’t fall any further – real interest rates, of course, can go negative – but because whatever the interest rate, the demand for liquidity is very high. Firms are operating as if they perceive a level of risk so high that even negative real interest rates wouldn’t motivate them to invest. It’s not that the market price has changed, it’s that the market is closed. Nobody wants anything but cash, and what they mostly want to do with it is to sit on it. Liquidity trap conditions could set in at interest rates quite a bit higher than the zero lower bound.
And we know this could happen, because several key financial markets did indeed just cease functioning in 2007-2008. First, the asset-backed commercial paper market, then the wider mortgage-backed securities market, and finally, the enormous interbank lending market just went dark. Rather than prices moving to unusual levels, there was simply no trade.
In thinking about how an austerity trap might happen, we need to look at both the “Keynesian” hydraulics and the expectations dimension. Hydraulically, here are three stylised facts. Firstly, the rich tend to spend less of their income than the poor. This is a consequence of diminishing returns. Secondly, investment is the swing item in the national accounts, the one with the greatest variance. Thirdly, budget consolidations very often seem to redistribute in favour of the rich or at least against the poor.
Just like that. It’s also worth noting that construction, the cyclical industry par excellence and one that is very labour intensive, plays a special role in the economy. Not only does it absorb a lot of public investment, public and private investment in construction have become closely integrated in the last 30 years. Private projects are subsidised by the state; state projects are designed to lever-in private investment.
So, here’s a story; budget consolidations tend to be levered-up because the people who lose out tended to spend the income they lost. Further, it’s easier to cut capital investment than current spending, so austerity tends to disproportionately hit the economy’s swing sector and especially construction, the swing item within the swing sector.
Now let’s look at it from an expectations/uncertainty point of view. One thing that baffled a lot of people in the UK was how quickly the trap hit once it was sprung. It is true that much of the spending cuts and the tax rises were planned for the future, and that budgets since 2010 have had the effect of pushing more of them off into the future. But it’s undeniable that the UK economy tanked. The transition was astonishingly swift. This can only be explained by a change in expectations, that is to say, estimates of the future.
The key expectations, I think, were those of earnings in real terms, and of the social wage. It is important that inflation post-crisis has been quite high in the UK, even using the CPI which doesn’t include housing costs. People were credibly informed that their real terms earnings would be reduced, and that the social wage was going to get a hammering. A major effort was made to convince them of this, after all. It should not be surprising that they put off big purchases, put up with poor wage settlements, and paid off debt as fast as possible. Similarly, businesses could also expect this and therefore curtailed investment.
The austerity trap, interestingly, makes sense both in expectations or Lucasian terms and in palaeo-Keynesian terms.