Tax Liquidity or Fall into its Trap

Falling consumption is feared more than most other economic phenomena  – not without reason, because when measured across society, it is a clear sign of distress. Three responses are possible: consumption will bounce back, goods will be hoarded, or production reduced. For the former to occur without a change in preferences, goods will have to be discounted, which, by reducing margins, encourages producers to scale back production. Physical hoarding may take root for a while, but such an expensive method of saving will not be sustained for long. So out of the three outcomes, a fall in production is the most likely to prevail; as a result, idleness is enforced not by any desire for greater leisure but rather by the ill-effects of unmitigated austerity. This is no fault of savers, whose self-restraint is the well from which all capital is drawn. Nevertheless, as long as its net effect is to inhibit production, frugality is self-defeating, since by contriving to bring about economic contraction, it undermines the position of savers themselves. Incidentally, this is a version of an argument made forcefully by Martin Wolf in several recent FT posts, and after developing these broad macroeconomic themes, I will make some further recommendations.

Unless suitably offset in society (i.e. by investment), the desire of savers to reduce consumption cannot succeed in increasing their combined claim to wealth, a false economy neatly expressed by Keynes’ ‘paradox of thrift’. Keynes believed that all efforts should be taken to avert the spectacle of savers’ self-denial being rendered futile by involuntary unemployment, a miserable state imposed by the failure to offset savings with investment. What impedes entrepreneurs from taking advantage of capital opportunities may be psychological, structural, or political in nature, and while  further discussion is merited, it falls outside the scope of this essay (though features in the previous post). Keynesian thinking, meanwhile, has traditionally been applied less to addressing the causes of crisis than to counteracting the effects on aggregate demand. Not surprisingly, in the current crisis, tools designed to boost aggregate demand in the face of dwindling private investment have garnered renewed interest (after decades of neglect). Further below I will pick up the thread of policy-making, especially in the context of deflation.

While sane savers would not want wealth production to decline, the importance of production being maintained if the desire to save is to be satisfied is rarely foremost in their minds. Saving entails deferring making purchases and accumulating purchasing power instead; nothing in this calculus influences whether production will be scaled-back as a result, which depends entirely on how producers respond to being unable to sell their wares. Warehousing unsold goods is deeply unsatisfactory, not only because of the associated rental costs, but also because hoping that goods that cannot be sold today will stand a better chance some time in the future is bordering on the reckless. Meanwhile, diversifying into other consumables leaves producers in the same structural position, assuming falling consumption was not driven by a paucity of sought-after goods, that is. The only viable option for producers is to diversify out of consumer goods entirely, and to produce capital and other high-order goods instead.

Capital formation is made possible by the ‘surplus labour’ produced by saving. Unless producer profits are sufficient in scale, this surplus labour will have to be ‘bought in’ if capital production is to commence. This financing function depends on savers being willing to redenominate income out of real goods and into financial instruments. While these instruments will one day need to be liquidated if savers are eventually to ‘overconsume’ (e.g. in old age), their austerity allows real goods to circulate and satisfy consumption demand exerted elsewhere. And because the demand to consume is to a large extent independent of the manner in which production is organised, a willingness to save facilitates the redeployment of productive forces from consumer into capital goods, from which a compensatory demand for consumables will stem, supporting production.

A process that is characterised figuratively as the channeling of savings into investment has the merit of forming a potentially virtuous circle of saving-stimulated productivity growth, on which savers’ interests ultimately rely. Keynes’ paradox of thrift only applies if frugality is met not with capital investment but instead with risk aversion. A fall in the rate of interest is the classical mechanism by which investor demand should respond positively to decreased consumption demand, although the financial market, dominated by a dysfunctional banking system, is not sufficiently free to allow this mechanism to work. This has traditionally been a matter of greater concern for Austrian School economists than for their Keynesian counterparts, who are prone to treating all investment demand equally. While Austrian School thinkers identify what they term ‘mal-investment’ as a cause of crisis, Keynesians have a tendency to treat any investment as welcome.

As mentioned earlier, physical hoarding (of goods, not scarce resources) cannot persist for too long because it will be suffocated by a consequent reduction in production. However, a milder variant may emerge in the form of ‘liquidity preference’. Broadly speaking, ‘liquidity’ measures the ease with which a saver can revert to consuming. Money is defined as the most liquid instrument available, and its promise of consumption-on-demand makes it highly prized among savers, whose interest in non-monetary instruments will only be piqued by a suitable offer of yield. The liquidity of money depends on the form it takes: for some time, physical currency was fixed (e.g. by the supply of gold), which meant that money could be hoarded – indeed more ruthlessly than any depreciating good could be. (This was once considered morally appealing: for the Enlightenment philosopher John Locke, hoarding gold was preferable to hoarding perishable goods, since the latter threatened starvation.)

Hoarding money certainly makes it less useful as a medium of exchange, which is, after all, its primary economic role. Under gold, liquidity preference was uncontrollable, and conspired in a tendency towards falling prices and underproduction that bedevilled society. So the removal of quantitative limits governing money in 1971 represented financial innovation, since if nothing else it meant hoarding money could be defeated. ‘Fiat’ money (so-called because its quantity could be determined under fiat i.e. arbitrarily) could now be supplied to meet any level of demand, and in a single stroke, gold ought to have lost its lustre. Yet the promise of abundant liquidity sold by the architects of fiat money, and repeated by their descendants in the banking system -the governor of fiat money- has proved hollow: liquidity is always scarce, no matter how money is constituted. If it is to mean anything at all, liquidity must speak to the ‘quantum’ of consumption that the instrument affords. If the supply of money is growing, its unitary purchasing power becomes volatile, dependent on the timing of purchases in relation to one another. If there is insufficient visibility regarding this, say if the money supply fluctuates (as now) in an unruly manner, the liquidity of money will be severely constrained.

Whether or not savers understand the liquidity limits of their deposits is unclear, though as I argue in earlier posts, the supposition that purely liquid, risk-free assets can earn interest should be evidence enough. Indulging liquidity preference by allowing the money supply to expand more or less on demand not only permits debilitating inflationary pressures to build up in the financial system; it has also failed to prevent a tendency towards deflation and depression from resurging, a deep embarrassment to the financial Establishment. Under the regime of fiat money, monetary policymakers were supposed to monitor general price movements for the risk of inflation, and yet by the early 1990s, arguably the most advanced economy at the time, Japan, had entered the grip of deflation, from which it is still to escape. It took flirtation with deflation some fifteen years later before Western policymakers were finally to be roused from a complacent, self-congratulatory belief in the advent of The Great Moderation.

Many commentators have sought to attribute deflation to falling consumption, which, while being a plausible marker of economic distress, as described above, cannot be regarded as its fundamental cause (except to the extent consumption is held down artificially). Politicians who focus on boosting consumption while stopping short of addressing the underlying problem, chronically weak investment, are guilty of conflating cause with effect – or worse, of populism. Nevertheless, in present circumstances even an agnostic boost to consumption may be part of the solution: where deflation is caused by slow-shifting stock encouraging producers to reduce factory gate prices, it can become endemic as consumers react by further postponing purchases in the widely-held anticipation of lower prices to come. Not only is saving as prompted by the allure of speculative gain unwelcome in and of itself -since it reduces consumption below the level that would otherwise have been targeted-, it serves to entrench even further a motivation for its continuation, i.e. falling prices. It is therefore understandable that authorities have sought to avert falling consumption either by running fiscal deficits or expanding the money supply, all in the hope of preventing deflation from setting in.

However, unless this corresponds with an increase in investment, Keynes’ central message is ignored. The co-conspirator with price discounting in entrenching deflation (and risking depression) is not falling consumption, but actually growing liquidity preference. When prices fall, postponing consumption rewards depositors with a greater claim to wealth, even before any interest accrues on their assets. Such economically sterile behaviour is indulged by our banking system and allowed to run amok in times of crisis. And because consumption is punished relative to holding money, deflation arises while production is discouraged, establishing a vicious cycle already well-rehearsed in the literature and media. What is typically left unexplored is the root cause, casually assumed to be falling consumption or deflation, or both. What’s more, while extended episodes of falling consumption almost always signal distress, deflation cannot be assumed to be symptomatic of stagnation, for it could just as easily accompany rising productivity.

Of course, the problem of deflation for policymakers (besides the difficulty in distinguishing from among possible causes) is that, unless actively resisted, it activates liquidity preference. Not only does retaining surplus liquidity inhibit the clearance of current stock and duly dampen production of consumables, it withholds finance needed for capital production and so snuffs out any remaining embers of growth. Note that the economic bad here is not deflation, but rather rampant liquidity preference, which, alongside deflation, establishes an economically lethal combination that produces Keynes’ “liquidity trap“. Until recently, this did not feature prominently in examinations of recession, with the result that instead of mitigating liquidity preference, money became much more abundant. If this was expected to forestall the prospect of a liquidity trap emerging, this has proved over-optimistic. Deflation cannot be extinguished with monetary expansion as long as agents are allowed (and prepared) to hoard it in ever-greater quantities, in an (ultimately futile) bid to insure themselves against economic crisis.

In previous posts I submitted some ideas as to how to contain liquidity preference within its natural economic borders, set by the desire to consume imminently. As part of this task, I outlined the basic terms of a renewed social contract that would, if enacted, make available to savers an abundance of risk-free alternatives to money offering a sliding scale of liquidity offset by yield. In a single stroke, money would be economised and the natural yield curve revealed. However, what I have not considered so far in my posts is how to neuter the specific effects that deflation could, by resurrecting liquidity preference, have on consumption.

The now-conventional wisdom states that one must always oppose deflation outright, and use monetary expansion as the tool (however discredited this approach appears in the light of recent experience). Implicit in this position is the false assumption that deflation is an economic bad, which fails to recognise that prices might just as well fall in response to benign economic forces. What has not been widely considered is whether instead of seeking to eliminate deflation, liquidity preference could be opposed so as to prevent deflation (whatever its cause) going on to hijack economic growth. A solution to this would be to tax liquidity at the rate of deflation, a version of a proposal made by Silvio Gesell in the early twentieth century, which occasionally resurfaces today, chiefly in the guise of negative deposit rates. With such a reform, demand for money would fall to the level needed for transacting; money would be economised, encouraging its velocity to settle on a stable level as money reverts to its classical role as medium of exchange; in turn, prices would become effective signals of supply and demand for goods, services and finance, a condition for a virtuous circle of growth to form.


3 Responses to “Tax Liquidity or Fall into its Trap”

  1. Tushar Shah Says:

    I found the essay very interesting. I’m not sure I’ve fully grasped all the nuances of your arguments – it may help me to get your views broadly on the level of leverage in the overall system that you think is appropriate – and to what extent government should be involved in setting/influencing a given level of leverage. The lens I’ve simplistically used to understand the current state of the economy in the developed world is – we’ve allowed ourselves to use increasing amounts of leverage at all levels of society (gov, individual, corporate) for the past 2-3 decades and we’re now going through a period of retrenchment through a process of deleveraging that will take a long time to work through. If I understand you correctly to some extend the structure of the current financial system as it is going through this crisis is resulting in not enough saved money getting to the hands of wealth creating folks. Is this a way of saying we’re deleveraging to quickly and to far far?

    • eg221 Says:

      Hi Tushar – thanks for your comment.

      By leverage I assume you refer to the role of debt in funding investment. Debt is a bilateral zero-sum contract through which the lender creates an asset and the borrower a liability. The establishment of debt does not alter the overall amount of wealth in existence, it brings about a reversible transfer of wealth. A saver who opts to lend his surpluses is willing to concede to someone else the opportunity to consume for a given period, during which time the borrower is able to redeploy his productivity away from subsistence needs (consumables) into capital goods. The key benefit of debt, therefore, is to marry the existence of savings with the possibility of capital (the key to enhanced productivity), the production of which establishes the means by which the debt is eventually redeemed.

      However, debt is not the only means of bringing capital into existence. Instead of entering into a fixed contract, a saver could decide to purchase a property right in future capital production i.e. to become the capitalist via some joint venture or shareholding arrangement. Here, rather than loaning the opportunity to consume to the entrepreneur under fixed terms, the saver contributes these funds upfront in exchange for the unknown end-product of capital. The saver has no recourse if the product is worthless and, in return for this precarious position, seeks control over production.

      The choice between debt and equity does not alter how much finance is available and therefore how much capital can be created. But there are differences: with debt, a contract is created which will be redeemed according to a predefined rule; with equity, no such contract exists, and the saver merges with the entrepreneur. Debt is less risky to the saver, and easy to arrange by the entrepreneur because provided it meets its obligations, its shareholding and control is unaffected. Equity, on the other hand, means the saver shares the full risks with the investor. Most importantly (in the context of your question), equity is difficult to arrange, and all the more so when there are multiple shareholders already and/or if equity is raised midway through a project: since existing shareholdings are being diluted, multilateral (not bilateral) negotiation among shareholders and share valuations will be required, introducing much scope for dissent and litigation. Most societies have had to establish a section of commercial law to deal specifically with the process by which groups of shareholders (corporates, partnerships) can go about raising new equity.

      Nevertheless, issuing debt is often preferred by firms seeking to finance capital growth, for which retaining executive control may be paramount. Mature corporates that have passed out of the capital growth phase often choose to refinance the bulk of debt by issuing equity. I am not aware of any ‘appropriate’ balance between debt and equity within the economy, since both are legitimate methods of financing capital, and appeal for different reasons to different types of savers. To my way of thinking this is a matter that should be left to principles of mutuality i.e. to the free will of savers and entrepreneurs in negotiations. Government has no rightful jurisdiction over these arrangements.

      The game-changer was the banking system’s control over savings. Banks are uniquely able to cross-sell public insurance to savers, who are attracted by risk-free financial instruments (deposits) in which to park purchasing power. Banks are also unique within the private sector in being able to create money, which they do by loaning out newly-created deposits. Accordingly, banks intermediate in most financial transactions by issuing debt (money) which borrowers can use to purchase goods and services. Financial intermediation and payment settlement functions have embedded banking in the heart of commerce.

      Banks have been especially keen to lend to households, which goes to your question directly. It is the household sector that, famously, has indebted itself in the West with reckless abandon, egged-on by banks scrambling to build market share. The profitability of this activity for banks was not rooted in the income of households, which has been stagnant for over two decades (and has reportedly been falling in the US in real terms for much of this period); it was based on rising house prices, which encouraged households to divert an unsustainable share of income into consumption and debt service rather than saving.

      Particularly in the US, negative household savings were financed from abroad. Not only were US banks happy to collude in this, foreign exporting countries (let’s call them China) have been content to offer vendor finance while they industrialised. China achieved two things: it has become much more productive at the same time as stockpiling hard currency, insurance against import prices of resources. Rising productivity and an artificially-weak remnimbi exported deflationary forces to the US, where interest rates fell as a result. This was the stimulus to house prices that completed the circle.

      Households only need finance to make one-off high-value acquisitions e.g. homes. Landownership obliges households not only to finance housing wealth, but also land, which represents the bulk of the expense. This explains why old houses rise in price: the housing stock itself is depreciating, but rising population and rising output increase rents and therefore land prices. As societies such as the US have become richer, households have had to borrow more, while seeing their share of national income decline. This was affordable while interest rates were falling, but as rates began to bounce, the crisis was triggered.

      Sentiment was the first victim, with banks suddenly fearing each others’ -and therefore their own- annihilation. They withdrew credit from households, who immediately curtailed consumption to repay debt, though not as quickly as their assets were contracting. Meanwhile Chinese exporters naturally responded to reduced sales by decreasing their financing of the US, exacerbating the declines in asset prices. This is obviously painful to US households in the first place. It also caused much of the domestic financial system to become insolvent, as house prices fell and bad loans rose. The state responded by bailing out the banks, as we know, and becoming more indebted in the process (also owing to falling tax receipts). At the same time, falling consumption being an ingredient in deflation -which risked a liquidity trap- encouraged the Fed to inject new base money directly, though little of this got spent (liquidity preference rose). What to do?! As you say, the key is investment i.e. new capital, albeit at the cost of rising public debt. Sadly this is not well-understood, and rising unemployment suggests labour is not being mobilised in capital projects (including in infrastructure, education) but just left idle, consuming without producing.

  2. Malcolm Ramsay Says:

    I just discovered Martin Wolf’s forum and was pleased to see your comments (and Carol Wilcox’s) about land, and found your link when I looked at earlier articles.

    I had a piece published on OpenDemocracy ( at the beginning of April approaching this subject from a different (non-economist’s) angle. I was hoping to make contact through it with others who see things in the same way, but the only responses I got were sceptical-to-hostile.

    If you’re interested in further discussion, it might be worth setting up an e-mail group; I have some (long-shot) plans for reform that I’d like to be able to discuss, but ours seems to be a lonely perspective.

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