liquidity trap: what is it? are we in one?

liquidity trap

Over the weekend, Charles Evans, president of the Federal Reserve Bank of Chicago, said at a Fed conference in Boston that he thought the US is in a “bona fide liquidity trap.”  His prescription to cue this situation:  a second round of quantitative easing (basically, the Fed trying directly to push down longer-term interest rates) plus inflation-level targeting (promising to continue loose money policy until inflation reaches 2%).  The purpose of the second is to try to assuage fears of deflation by money market participants.

What does all this mean?

what it is

When the Fed, or any central bank, lowers short-term interest rates, the move has a whole series of effects:

–the initial move signals that the short-term direction of policy is reversing;  the money authority wants to encourage faster economic growth, not slow down inflation

–lower returns on savings instruments tied to short-term rates encourages people to spend money rather than to leave it in the bank

–lower rates on lending money tend to encourage consumers to borrow to finance consumption;  to the extent that younger people tend to be borrowers and senior citizens savers, economic power undergoes a demographic shift that puts money in the hands of those more likely to consume

–arbitrage extends the lowering of rates to longer-maturity debt instruments; lower long-term rates make company investment projects more economically attractive and thus encourage spending on capacity expansion and new hiring.

You can, in theory–and, looking at Japan over the past twenty years, in practice–envision circumstances where this process of lowering interest rates to stimulate economic activity won’t work.  That’s a liquidity trap.  The money authority lowers rates but gets no economic response.

Economists have, not always clearly, distinguished between two types of liquidity trap:

1.  deflationary, sometimes called the “zero bound” case.  The goal of accommodative money policy is to lower nominal rates until they are negative in real terms.  The idea is that once the saver realizes he is no longer even preserving his purchasing power by holding short-term deposits, he will boost his consumption and look for (riskier) investments where he can earn a positive real return.

But nominal rates can in practice only be reduced to zero.  If prices are falling (which is what deflation is), real rates stay high despite the best efforts of the money authority.  If prices are dropping by 3% a year, for example, a zero nominal rate is a 3% real rate.  As a result, savers don’t budge.

There have been instances of negative nominal interest rates–like in Hong Kong in the late 1990s, when the government there announced plans to charge a recurring fee to foreigners for holding bank deposits.  But they’re a practical impossibility.

2.  a “true” liquidity trap, or “pushing on a string.”  The idea is that a point might be reached where central bank action in pumping ever larger amounts of money into the economy would have no further positive effect.  The economy would, in a sense, be saturated with money.  The original thought was that interest rates would remain above zero but would not decline further, despite the efforts of the central bank to push them down.  But the idea can easily be expanded to include other cases where money polity is ineffective:  the transmission mechanism may break down if economic entities are frightened and want to hold precautionary balances even though they earn no economic return; or there may be enough regulatory or government policy uncertainty that it’s hard to identify viable projects to invest in.

where we are now

In the US, inflation has been running at about 1% over the past year or so.  The sharp decline in the dollar over the past several months suggests that, if anything, inflation will rise a bit as we head into 2011.  So, although policy makers and economists may fear deflation, we’re not in that situation today.  That means type #1 above doesn’t apply to us.

There’s a lot of liquidity sloshing around in the US–in the whole world, for that matter.  Several private companies have been able to borrow money at a fixed rate for fifty years or more.  Mexico, despite its history of economic meltdowns and its internal political difficulties, has recently successfully issued a hundred year fixed-rate bond.

This leaves us with breakdown in the transmission mechanism as the reason why money policy has become ineffective.

Mr. Evans of the Chicago Fed seems to think that fear of deflation is the main problem, or at least that’s what his remedy of in effect having the Fed promise to create 2% inflation suggests.  Other economists lack of enthusiastic support suggests his is a lone voice.

This leaves the possibility that attractive investment projects are hard to find.  In a recent speech, the head of the Minnesota Fed, Narayana Kocherlakota, suggested that the gating factor may be lack of skilled workers.  The sound bite the press picked up was his observation that the Fed has no ability to turn construction workers into machinery workers.  He also pointed out that Bureau of Labor Statistics data indicate the economy has about 800,000 more unfilled jobs now than it did in March 2009.

It’s also at least a logical possibility that uncertainty about medical care costs or about future taxes is at the root of companies’ reluctance to invest domestically.  Given that the Fed members are political appointees, though, I think there’s a pragmatic limit to what they’re willing to say in print.  To me, however, it’s clear the Fed thinks a dysfunctional congress and an ineffective president are the reasons the current liquidity trap persists.

I think adjustment to the new economic circumstances is already taking place.  Lack of effective regulation and supportive legislation will just mean the transition process is a longer one.