Ryan and I talked about this, but I thought everyone might be interested. It takes a while to understand what a liquidity trap is. We are in one, and here is a good start. *** Happy Anniversary to the liquidity trap! This is the fifth anniversary of America and much of the rest of the world being in a liquidity trap - that is, interest rates are basically zero. It was in late October of 2008 that the Fed funds rate (banks lending to banks) hit basically zero. Economically speaking, being in a liquidity trap is a Bizarro World. In this world virtue is vice and vice is virtue, and that explains why policy makers in Washington can not figure out how to get us out of this mess. Here is what I mean by that: 1. Normally, when the economy is down, the Federal Reserve can lower interest rates. The cheaper money will encourage people to spend and stimulate the economy. Not when you are in a liquidity trap. Interest rates are already zero, and in the real world you can not have negative interest rates. People will just hold cash. 2. Normally saving is a virtue. However, in a liquidity trap, everyone is saving and paying down debt. With no one spending, the layoffs begin. But the layoffs scare people so they save more, and that produces more layoffs. 3. Normally, the government should not do a lot of printing of money, because it will cause inflation. Not when you are in a liquidity trap. The money will end up sitting in the banks as bank reserves and will do nothing. Well, if people think inflation is going to happen, the expectation can effect peoples spending. This increase or decrease of the money supply is the normal way the Federal Reserve stimulates or slows an overheated economy and is known as monetary policy. In the Bizarro World of the liquidity trap, monetary policy is useless accept for impacting expectations. 4. Normally, the government should balance its budget or pay down debt, but not when you are in a liquidity trap. Now the paradox of thrift applies. In a liquidity trap, if the government cuts back, it only adds to the economic contraction being created by the citizens doing more saving and paying down debt. Known as fiscal policies, the government needs to spend, hopefully wisely, to keep the economy going. The government can only cut back after interest rates are higher. Then the contraction caused by the government cutback can be counterbalanced by the Fed decreasing interest rates. The point, you pay off debt in the good times. (The money comes from taxing, borrowing, and/or shifting money to areas that create more jobs) 5. Normally, economist would say that wage flexibility or lower wages can increase economic competitiveness and improve the economy. Not when you are in a liquidity trap. In a liquidity trap, you are subject to the paradox of flexibility. Low wages mean less for people to spend and less spending contracts the economy even more. Then, as the economy contracts, businesses want to pay even lower wages. What you should do is the reverse, such as increase the minimum wage. There is more, but I will stop there. As I said, this is the Bizarro World, but, guess what? It is the new normal. If it has been going on for five years, it is the new normal. The only question is, how long will it take before people learn the new economic rules in this new Bizarro World?
Posted on: Wed, 16 Oct 2013 16:44:17 +0000
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