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.

prospects for deflation: Andre Meier and Gavyn Davies

Gavyn Davies as blogger

Gavyn Davies, formerly chief economist for Goldman Sachs, then head of the BBC, is now among other things a blogger for The Financial Times.

My experience as a portfolio manager has been that Goldman’s economic commentary has always been truly excellent, and the high spot of the firm’s research offerings. As to Mr. Davies in particular, I read and admired his work for years.  (Equity strategy and individual stock research at Goldman is another story—lots of facts, no useful opinions would be my call.)

A recent post on his FT blog talks about deflation.

The  deflation problem, in a nutshell,  is this:  the main tool governments use to treat a sick economy is to lower interest rates to the point where the real (that is, after adjusting for changes in the price level) cost of funds is less than zero.  But an agency like the Fed can only lower rates to zero, where they are now.  It draws the line at actually paying us for the privilege of lending us money.

Because of this, a deflationary economy, i.e., one with a falling price level, is like having a patient with an antibiotic-resistant virus.  You can’t make real rates negative.  So tried and true treatment methods for curing a slumping economy are ineffective.  The monetary authority can either try unconventional methods, which have no track record, or stand on the sidelines with fingers crossed, hoping the patient recovers on his own.

It doesn’t help matters that the word deflation conjures up images of the worldwide depression of the 1930s or the decades-long stagnation of Japan.

Andre Meier on deflation threats

In his post, Mr. Davies cites work by Andre Meier of the IMF in cataloging and analyzing all the instances of recessions in the developed world over the past forty years that have been serious enough to pose a deflation threat.

Mr. Meier’s conclusion:  while inflation does rapidly approach the zero level in the twenty-five instances he looks at, it doesn’t seem to want to cross over into negative (deflationary) territory.  The higher the previous inflation, the faster the plunge downward, but in all cases save two the rate of descent slows and the inflation rate stabilizes as the zero line is reached.

In pre-1990 instances, which tend to originate at higher inflation levels, the march to zero is relatively steady.  Post 1990, the initial fall is sharp, but disinflation then tends to decelerate in later periods.  In the two exceptional cases from the past paragraph, which start from very low initial levels of inflation, Sweden in 1992-94 and Japan 2001-2003, the price level actually starts to rise as the recession deepens (presumably because of currency weakness and imported commodity strength, but odd nonetheless).


Both economists interpret the data as indicating that there’s something very unusual about the occurrence of deflation, and that it seems to take negative economic shocks of much larger magnitude than the world has seen at any time in the post-WWII era–including now–for deflation to take hold.

The question is why this is the case.  Both Meier and Davies point to structural rigidities around zero.  As a practical matter, firms are reluctant to cut the wages of highly skilled employees, for fear they’ll leave when economic conditions improve.  They don’t want to cut the prices of their output, either.  Experience has taught them that it’s extremely difficult–in many cases, nearly impossible–to raise them back again.  In addition, in many cases legally binding agreements–government workers’ salaries, for example, or long-term materials supply contracts–mean price cuts aren’t possible.

On a macroeconomic level, it may be that inflationary expectations–there’ll be low inflation but at least some–have been very deeply established in our collective economic psyches.  World governments response to recent crises, much as we may want to criticize the details, may have been enough to preserve or reinforce these attitudes.

In any event, the experience of the last forty years says deflation is not likely to happen.

my thoughts

No deflation doesn’t mean everything is ok.  But if we take the idea that general price levels are not going to decline as a working hypothesis, we can draw conclusions that may have useful investment implications.  For example, if salary levels aren’t going to decline, then firms will only be able to lower labor costs by laying workers off, or by pruning high-cost but unproductive workers and replacing them with lower-cost, more productive ones.  Companies could also prioritize between high value-added tasks and low value-added ones–and focus all/most compensation increases to workers in the former areas.

One might also try to distinguish countries where limited economic gains may be a chronic problem and those (like the BRICs) where it will not.

In discussing its most recent earnings performance, Procter and Gamble seems to be saying that these sorts of patterns are already becoming evident in their customers’ behavior.  For example, PG is finding that consumers of mainline/premium brands are beginning to trade up.  Value-brand users are continuing to trade down.

My experience is that in uncertain economic times, investors tend to become mesmerized by worry over the worst possible outcome and do little else except wring their hands.  True, we need to be concerned about even low probability events that have significant negative consequences.  But typically this doesn’t take much time.  I think there’s potentially a lot of money to be made by looking for hot spots of growth even in a world that may not be expanding that quickly.  And there’s certainly money to be made by working out the economic implications of having something better than the worst-case scenario unfold.

inflation vs. deflation: where are we now?

Because the two words, inflation and deflation, look alike, they invite the conclusion that there’s a single phenomenon– -flation–that has two varieties, de- and in-.  As a practical matter, despite the similar names, inflation and deflation are actually quite different in how they affect an economy.   In the US at present, knowledgeable politicians (an oxymoron?) and economists have their fingers crossed that inflation somehow resurfaces and that deflation will not become an issue.


An economy with inflation is one where the price of things in general is rising.  It isn’t enough that some prices are rising–even very visible prices like gasoline or movie tickets.  In an inflationary economy, overall prices have to be rising, so that the cost of living steadily goes up. (I wrote about inflation more extensively in a post from May 25, 2009.)

In a developed economy like the US, the only price that really counts for inflation is the price of labor.

If inflation had a tendency to stay well-behaved, at a constant, low rate, it wouldn’t be much of a problem.  But it usually doesn’t do either.  One way to think about what happens is this:

in an inflationary environment, some people underestimate inflation.  They think prices will rise by, say, 3% in the coming year.  They ask for and get a 3% wage increase.  But inflation turns out to be 4%, so in real (i.e., adjusted for price-level changes) terms they are making less than they used to.  So the following year, they ask for a 6% raise.   Others ask for and receive a 5% raise, so they’re better off in real terms than before.  So they try to do the same thing the following year.  As a result, the rate at which prices are rising tends to increase.

At some point, expectations change. Companies start to raise the prices of their output and individual wage earners up their wage demands in anticipation of, and as protection against, future inflation increases.  In doing so, they create the increased inflation they fear.

As inflation accelerates, people start spending more and more time defending against future price increases and trying to work the situation in their favor.  This means less time doing productive work.  At more advanced stages, capital investment in long-term projects slows, because figuring out its profitability may depend on forecasting accurately what inflation will be ten years hence–which has become impossible.  For the same reason, no one wants to hold fixed income securities, including government debt.

In the worst case, hyperinflation (think:  Japan or Germany close to a century ago, or Brazil twenty years ago), the economy comes close to collapse.

The (relative) good news about inflation is that it’s a well-understood phenomenon.  Any government knows what to do to remedy the situation:  restrictive policy (higher interest rates, plus maybe less government spending and higher taxes) until inflation begins to decline and expectations in the economy change.   The real stumbling block to an inflation cure is having the political will to implement it and a Paul Volcker-like central banker to oversee the process.


In its definition, deflation is the opposite of inflation.  It’s a steady, general fall in the price level.  To my mind, three factors make deflation something different from a mirror image of inflation.

1.  Deflation is weird. Other than the Great Depression or the Weimar Republic, it hasn’t occurred very often in the contemporary world.  Other than maybe the PC industry, no one is set up either psychologically or institutionally for deflation.  Suppose prices were falling at a steady annual rate of 2%.  What would you think of a government bond where you paid $1000, received no interest income and got back $900 in ten years?  Me, too.  Credit creation, and all the economic activity that depends on it, would stop dead in its tracks.

2.  Deflation makes outstanding debt that carries a positive nominal interest rate (in other words, all of it) a crushing burden.  Prices dropping 2% per year means, among other things, wages dropping 2% annually.  Let’s change the rate to 5% just to make the point easier to see.  At the end of five years, you’re making 77% of what you were before deflation hit (ignore the fact that falling wages suggests widespread unemployment and other horrible economic problems).  Yes, the cost of food and clothing has probably fallen in line with your income, but your mortgage and credit card payments haven’t.  If your credit payments were 25% of your income pre-deflation, they’re a third–and rising–of your income now.

The situation is worse for companies with operating leverage, whose profits can quickly disappear.  Imagine, too, the state of private equity or commercial real estate, which depend on high levels of financial leverage for their viability.  They’re toast.

This, of course, has knock-on negative effects on the banking system.  Look at the Thirties.

What a mess!

3.  Traditional money policy becomes ineffective.  The orthodox central bank response to recession is to lower short-term interest rates until they’re negative in real terms.  The fact that finance is in effect free is supposed to stimulate borrowing, and therefore reinvigorate economic activity.  But the central bank can’t push nominal (i.e., not adjusted for inflation/deflation) short rates below zero.  So in a deflationary environment, the central bank can’t achieve the “free money” outcome.

This means that a country depends completely on fiscal stimulus–increased government spending–to help the economy improve.  But legislative action may be slow.  There’s huge potential for spending programs to be applied in pork barrel ways that will do little more than run up the government’s debt burden (think:  Japan since 1990).

where are we now?

There’s good news and bad news, in my opinion.  Bad news first.

Government stimulus programs seem to me to have so far been focussed on whatever is “shovel ready,”  without much thought about addressing long-term structural problems like education.  Maybe that will change.  But to date Washington looks scarily like Tokyo circa 1990.

The good news–

Europe’s pain is our gain.  US government spending depends on the continuing willingness of foreigners, notably China, to lend Washington money.  Prior to the Athens-induced collapse of the euro, Beijing appears to be warming up to shift its lending activity away from the US.  Not any more.  So no matter how inefficient government stimulus may be, at least it does something positive, and it won’t come to a screeching halt.

Also, lots of companies are announcing that business has become good enough that they are beginning to raise wages again and reinstitute benefits cut during the recession.  Given that wages are the most important element of changes in the price level in the US, this suggests that the current near-zero inflation rate is a cyclical low point and that the price level will rise from here.  To some extent, this movement in the private sector will be offset by changes in state and local government workers’ payrolls (some studies claim that municipal employees are now paid 20% more than private sector workers for the same jobs).  Still,  I think the private sector trend is grounds for a loud sigh of relief.