## No, Cliff Asness Still Has Not Done His Homework on What a Liquidity Trap Is: Why Do You Ask?

The Inflation Imputation: "In 2010, I co-signed an open letter warning that the Fed's experiment...

...with an unprecedented level of loose monetary policy... created a risk of serious inflation....Paul Krugman lived up to his lifelong motto of "stay classy" with a piece on the subject entitled Knaves, Fools, and Quantitative Easing. Some lesser lights of the Keynesian firmament have also jumped in.... Responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it's necessary....

We did not make a prediction.... We warned of a risk....

What everyone... missed... was how little money would circulate.... The Fed clearly wanted this money lent by banks and spent.... They didn't get that, and we didn't get the inflation we feared.... How this is a victory for one side of the debate or another is beyond me, but obviously clear to Paul and his back-up singers....

Also remember, much like when the Germans bombed Pearl Harbor, nothing is over yet. The Fed has not undone its extraordinary loose monetary policy and is just now stopping its direct QE purchases. When monetary policy is back to historic norms, and economic growth is once again strong, a normal number of people are seeking and getting jobs, and inflation has not reared its head, I think we can close the books on this one....

We have indeed observed tremendous inflation in asset prices.... Inflation is hard enough to forecast, but where it lands is even harder. If one counts asset inflation it seems we've indeed had tremendous inflation....

Now for a real prediction: Paul will continue to be mostly wrong, mostly dishonest about it, incredibly rude, and in a crass class by himself (admittedly I attempt these heights sometimes but sadly fall far short). That is a prediction I'm willing to make over any horizon, offering considerable odds, and with no sneaky forecasts of merely "heightened risks." Any takers?"

The part that I have bolded does, I think, demonstrate to everyone rational's satisfaction that Asness still as not done his homework.

The entire point of the analysis of the liquidity trap since the 1930s has been that at the zero lower bound the substitutability of bonds and cash becomes very, very high: there is no opportunity cost in holding money rather than bonds. As a result:

• The velocity of money becomes indeterminate, and the level of spending is no longer determined as equal to the money stock times the velocity of money by the requirement that households and businesses hold their desired quantity of money balances.
• Instead, the velocity of money is determined as the level of spending divided by the money stock.
• Instead, the level of spending is determined as equal to that level at which S=I by the requirement that households and businesses hold their desired quantity of financial savings vehicles.
• If you understand how the liquidity trap works, you don't expect quantitative easing to have large effects--and the failure of quantitative easing to have large effects comes as no surprise.

That was what Paul Krugman has been arguing since at least... 1998, I believe:

Japan 1998: "Here’s the little wonkish paper (pdf) I wrote back in 1998...

...the one that alerted me to the danger of falling into a liquidity trap, so that I was intellectually prepared for the mess we’re in. The whole point of that paper was that when you’re up against the zero lower bound, it doesn’t matter how much money you print--not unless you credibly promise higher inflation...

So, yes, it is very clear to Paul Krugman and to his back-up singers that quantitative easing's effects are small unless it is taken as a credible signal of a régime change and thus generates a significant shift in expectations of inflation. It wasn't. So it didn't. That it had at best small effects is an intellectual win for the Keynesian side here.

Everybody who has done their homework recognizes that.

Cliff Asness appears to believe that Paul Krugman's beliefs are in some sense the flip side of his--that while Asness believed that QE would produce high inflation, instead Krugman believed that QE would produce a real economic boom: The Fed clearly wanted this money lent by banks and spent.... They didn't get that, and we didn't get the inflation we feared.... How this is a victory for one side of the debate or another is beyond me....

It is as if Asness never bothered to read things like this:

Not so easing (wonkish) - NYTimes.com: "Goldman Sachs report (no link) suggest[s] that the Fed’s policy of ‘unconventional easing’...

...isn’t very effective... that it would take between $1 trillion and$1.6 trillion of unconventional easing to accomplish as much as the Fed can achieve, in normal times, by cutting the Fed funds rate by 1 percentage point.... Bernanke and the Fed... have been gaming out what they would do if ‘it’ happened here for years. And a key element of the strategy was altering the composition of the Fed’s balance sheet--that is, unconventional easing. But that tool isn’t proving very potent.

And, truth to tell, Asness probably didn't both.

It's difficult to know what to say under such circumstances.