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Wednesday, January 21, 2009

DOES THE USA SUFFER FROM A LIQUIDITY TRAP THAT NULLIFIES EFFECTIVE MONETARY POLICY? DID IT IN THE GREAT DEPRESSION ERA?

Today's Buggy Topic

It's found in lengthy prof bug analysis set out at the Marginal Revolution ---specifically, in a thread that the head of that impressive economic blog, Professor Tyler Cowen, started on the topic of a liquidity trap.

Meaning?  It's a theoretical construct that John Maynard Keynes created in his path-breaking book, The General Theory of Employment, Interest and Money . . . a difficult work to interpret accurately, despite Keynes just reputation as a gifted writer.  All the same, it clearly broke with the dominant economic theories of the day regarding the 7 year-old Great Depression --- Keynes book published in 1936 --- and created the new field of a separate macroeconomics.  The long buggy commentary left in the Marginal Revolution thread deals with a crucial series of reasons why Keynes --- called by Milton Friedman, the father of modern monetarism (for which Friedman, among other things, won a Nobel Economic Prize) --- had to repudiate many of the ideas that he developed at length on economics, and especially his belief set out in his two volume work in 1930, Treatise on Money, that energetic and deliberate monetary expansion by Central Banks like our Federal Reserve could stop deflation, plunging GDP, and sharply rising unemployment with monetary policy alone. 

No need in those early days of the Great Depression for active fiscal policy stimuli of the sort that Keynes later proclaimed in The General Theory were alone likely to bring the economic crisis in the US, Great Britain, and virtually everywhere in the world to an end. 

Among Other Things, The Substantive Buggy Argument

. . . explains the reasons for Keynes drastic change of thinking on monetary policy and his endorsement of the crucial need for large fiscal expansionary policies in its place.  It's exactly what President Obama is planning to do, just as several governments in the EU and in Japan have been doing too . . . even as their and our Central Banks continue to pursue high-octane monetary policies such as reducing short-term nominal interest rates to zero, buying now long-term financial assets to reduce long-term interest rates, recapitalizing the banking system, and expanding directly the money supply.

Keynes and his more committed followers in contemporary economics doubt that these monetary policies will work to end our credit-crunch, and so they emphasize even far larger fiscal stimuli policies than President Obama's announced $800 billion government spending . . . including on public works.  In Britain, believe it or not, the existing Labour government has committed to spending an astronomical sum --- equal to 70% of Britain's GDP $2.2 trillion (allowing for purchasing power parity).  That would be the equivalent in the USA of spending over $10 trillion!  Wow!

Enter the Liquidity Trap

What Keynes had in mind by this new construct was this: the demand by the public for holding money to make purchases of goods and services currently and in the near-term --- whether held as currency (dollars and coins) or checking accounts in banks --- wasn't the only reason the public, especially affluent and rich people with large savings, wanted to hold money in a highly depressed economy that coincided with a system-wide financial breakdown and a credit crunch.  On the contrary, so Keynes argued, the demand for money --- which Keynes called liquidity-preference (as opposed to investing savings in the bond and stock markets) --- was highly sensitive to interest rates.

At high levels of real interest rates --- which takes into account inflationary trends in the price level of the economy --- it became very costly to hold money for what Keynes called reasons of uncertainty and worry about the future . . . more technically, he called them for speculative and precautionary reasons.  And so the demand to hold money for such reasons became very costly.  At low interest rates, though --- if enough worry and uncertainty about the current, near-term, and long-term prospects of the economy materialized (exactly the case in the 1930s, and possibly, some say, now) --- the demand for holding money not just for consumption-purposes but speculative and precautionary reasons meant that the demand curve for money would become horizontal and infinite. 

To clarify briefly: people with savings would, among other things, fear that financial investments in the stock market were too risky; and in the bond markets, there was the added risk that if you bought, say, $100 million with a promised interest-rate return of 1.5%, the bond market might turn favorable in the future.  In that case, the demand for transforming held savings into bonds would lead to a fall in the price of the bonds that  raised the interest-rate , say, to 4.0% in real terms (keep in mind, interest rates move oppositely to the prices of bonds).  The result?  Your $100 million worth of bonds would suffer huge capital losses.  Sure, you could hold onto the $100 million bonds, and get a return of $1.5 million a year.  But others who had large savings too and waited could now buy $100 million worth of bonds and get a return of $4 billion a year . . . a huge advantage.  And any effort by you to sell your low-return bonds and move, let's say, the money into the now booming stock market would bring you far less than $100 million in their sale.

The Result?

In Keynes' view, the added fear of capital-gains losses in the future compounded the existing worries and fears among affluent individuals and financial institutions about investing in either the bond or stock markets . . . though it's the bond markets for short-  and long-term financial assets that directly influenced the rise and fall of interest rates. 

To stimulate business investment, low interest rates in a serious recession were desirable.  The same is true for households looking for loans to buy cars, houses, and other important durable goods on credit.  But, Keynes argued in 1936 --- opposite to what he had argued in 1930 --- real interest rates couldn't fall low enough in a big recession to kick-start investment and consumption this way.  The reason?  The liquidity trap itself --- the infinitely demand for hoarding money for speculative and precautionary reasons instead of investing even large amounts in the bond markets. 

In such cases, the nominal interest rate is held too high to stimulate sufficient business investment and private consumption to bring the overall national economy out of the recession.  It runs up against a floor --- or so Keynes argued.  And so the more thorough-going Keynesians like Paul Krugman still argue.

Nor was that all. 

On Top of All This, Banks Might Be Unwilling to Lend Out Money

Monetary policy could expand bank reserves easily.  Right now, banks are obligated by law to hold 10% of their deposits in reserves (in their vaults or in very short-term Treasury bills of a few months duration). 

Banks, of course, are in business to take their customers' deposits --- on which they now pay interest, even on checking accounts --- and lending out the 90% remainder to the public . . . businesses of all size and credit-worthy households.  In a credit-crunch like now, though --- as in the 1930s --- banks might be stuck with all sorts of troubled assets: many of the existing ones like those for houses might be defaulted on.  In that case, they may be reluctant to lend out their depositors money to the full 90%.  Instead, they might let more and more of it pile up instead of undertaking even low-risk loans to businesses and individuals.  And if they have an alternative of investing those excess reserves in very safe if low interest-rate US Treasury bills --- now fetching only 0.33% return --- they could be sure of getting at least some totally safe return. 

The result?  Further limits to the effectiveness of monetary expansionary policies to get us out of the current recession and credit-crunch.  Or so Keynesians argue.

Click here for the buggy take on all this at the Marginal Revolution.