ECON430-Topic #4: Liquidity Traps

Arnold Kling recently made a bit of noise about defining liquidity traps, and essentially falls into the camp of economists that believe that liquidity traps are as likely as unicorns. Paul Krugman has been outspoken discussing the liquidity traps in the U.S. and Japan, and responds to Kling on more than one occasion. (See links within for more detail). What seems to be a major sticking point here is that Kling’s claim is that a central bank is never in a “trap” (as Admiral Ackbar might say) since it could always debase it’s currency, and create any level of inflation that it deemed necessary. Krugman’s claim is that a liquidity trap is

The economy is in a liquidity trap when even a zero nominal interest rate isn’t enough to restore full employment. That’s it. (linked above also)

which is less extreme than the claim of Kling. It could be that Krugman has redefined liquidity traps over the years, but there seems to be a more political take on what central banks can do. It seems likely that the central bank cannot in fact simply print as much money as it wants, create hyperinflation, and then restore full employment. There is not likely the political willpower in the Congress to allow the Fed to force the hand of the Chinese or Japanese to sell off their U.S. denominated assets and “beggar thy neighbor” back to wealth. As the global “reserve currency” the U.S. monetary authorities are somewhat limited in their actual response. Thus, the term trap seems to still apply since the Fed could “theoretically” do something but not “practically” do the same action.

The unintended consequences of our monetary policy might spread much further than we can imagine. If food and energy price inflation has risen because of QE2, what would happen if the Fed pushed for further policy prescriptions that are discussed as a way of escaping liquidity traps? Does our central bank have a greater responsibility than just to the people of the U.S. since we are so central to global financial markets?

Questions to think about

  • Do you believe the U.S. is in a liquidity trap? Look at other sources to define and confirm your definition?
  • If we are in a liquidity trap, how should we get out? What are the recommendations you would make to the central bank, and what are the consequences of that policy?
  • How do you believe foreign governments can or should respond to the U.S. demands for currency debasement (if that is your recommendation)?
  • What other consequences might there be from enacting liquidity trap “policy prescriptions”?

Like always, please don’t try to answer all of these questions. Focus on one main idea.

14 thoughts on “ECON430-Topic #4: Liquidity Traps”

  1. I do not believe the U.S. is currently in a liquidity trap although nominal interest rates are essentially zero because there are other actions the Fed can take to restore the economy to full employment. Also, Charles Rowley criticizes Krugman stating the monetary problem confronting the Fed is not demand-based and not a liquidity trap problem at all. “It is a money supply problem. It is an inability to move high-powered money through the money multiplier into the supply side of the equation.” [1] Many small banks and business are demanding funds but evidence shows the larger banks are still not lending despite the accommodative environment. [2] As of this March, bank reserves with the Fed have continued to increase and reach new records. [3] This could be because banks are still afraid to make risky loans while they are cleaning up their balance sheets or some believe it’s a combination of that and interest being paid on excess reserves discouraging the incentive to lend. [4] Regardless, the Fed has other options it can take such as continue to purchase longer-term government securities or other assets, raise their inflation targets in a credible way or, as a last resort, depreciate the currency. With all these options to help restore full employment, it makes it hard to believe the U.S. is in a liquidity trap.

    [1] http://charlesrowley.wordpress.com/tag/paul-krugman/
    [2] http://dailycapitalist.com/2011/02/12/are-banks-lending-a-report-from-the-trenches-part-i/
    [3] http://www.minyanville.com/businessmarkets/articles/pomo-permanent-open-market-operations-fed/3/14/2011/id/33333
    [4] http://seekingalpha.com/article/256778-what-about-all-those-bank-reserves
    [5]http://krugman.blogs.nytimes.com/2010/03/17/how-much-of-the-world-is-in-a-liquidity-trap/

  2. Based on Krugman’s definition of liquidity trap, the US is experiencing a liquidity trap and I certainly agree with this claim for several reasons. Looking at the growth rate of M0 (monetary base) no one has any doubt that the Fed has been on a “printing spree” however despite that; economic growth has still been lackluster with unemployment hovering in the 8-9% range [1], [2]. This in effect has caused the US dollar to depreciate significantly against all the major currencies in the world [3]. Secondly, unconventional monetary policy such as QE has had little effect on economic performance. At the end of the day it’s really not about how much money the Fed itself pumps into the economy but more about how much of (M1) money supply changes. In considering Kling’s suggestions to get out a LT there’s an important element that he seems to neglect which is the issue of external dynamics that might be at work preventing the central bank from excessive printing of money or currency debasement. In the United States’ case there is the issue of China’s currency undervaluation, debasing the currency will not yield results unless China revalues its currency to a competitive level. Also, the political implications domestically and internationally of this kind of currency manipulation, as such a move might be met with major resistance. In terms of how to get out of liquidity trap, fiscal policy through deficit spending might be the solution [5] e.g. New Deal. However, with the current Federal debt situation continued government borrowing can lead to an implosion in the economy if the US is downgraded.

    1. http://research.stlouisfed.org/fred2/series/BASE
    2. http://research.stlouisfed.org/fred2/series/UNRATE
    3. http://www.economist.com/node/14700644?story_id=E1_TQSDDGQQ
    4. http://krugman.blogs.nytimes.com/2010/03/17/how-much-of-the-world-is-in-a-liquidity-trap/
    5. http://web.pdx.edu/~ito/Liquidity_trap_RE_-HI2.pdf

  3. If we are in a liquidity trap, the central bank should pursue inflationary policy. The central bank should change people’s expectations towards prices and create some inflation which could stimulate the economy. Having interest rates very low and low inflation, hoarding liquidity is not a bad idea for business and consumers, but adding inflation expectations and some actual inflation, the opportunity cost of holding currency will increase and business and consumers will respond by increasing money’s productivity. “By encouraging Americans to believe prices will start rising at a faster pace, the Fed would reduce inflation-adjusted interest rates and stimulate the economy” [1]. “Central bankers and the public generally loathe the idea that even a temporarily higher inflation rate could be beneficial or be consistent with price stability over the longer term”[2]. One consequence of inflation is rising prices will affect our currency which could be beneficial for our trade balance. Also, inflation is perceived to be bad in America, so the decay of consumers’ purchasing power would not be favorable for the politics on the government. There the conflict among the dual mandate of targeting unemployment and inflation goal is inefficient during a liquidity tarp. “The central bank is missing both components of its dual mandate by a large margin, there is justification for targeting a higher price-level path in an effective, disciplined and limited fashion” [3]. Nevertheless, reducing the incentive of hoarding money will result in increase in economic activity which can subsequently help get the economy out of a liquidity tarp. “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” [4]”
    [1] http://www.businessweek.com/news/2010-10-16/evans-says-u-s-in-liquidity-trap-needs-fed-action.html
    [2][3] http://online.wsj.com/article/SB10001424052748704706904575556283044368588.html
    [4] http://krugman.blogs.nytimes.com/2010/08/31/japan-1998/

  4. I agree with Kling’s definition of a liquidity trap, defined by “…an infinite elasticity of the demand for money. The central bank can expand the money supply to an unlimited degree, without affecting interest rates, output, or prices” [1]. While the U.S. is not there yet, we seem to be pretty close. Looking at the M1 monetary multiplier, there is clearly a sharp decline in the multiplier, suggesting that addition M0 is not as effective in increasing M1 as it was prior to the recession [2]. Many analysts claim that QE2 is creating inflation in commodities, but this has not translated into core inflation yet [3] [4]. While talking heads worry about hyperinflation, the Fed may be more concerned about stagnation with no means to combat it.
    With other countries holding U.S dollars as reserve currency, a devaluation of the dollar would most likely be matched by China and the Euro zone. Therefore, the Fed should attempt to anchor inflation expectation, either with a more firm commitment that their implicit target or by making structural changes that encourage banks to lend (maybe ending IOER).

    [1] http://econlog.econlib.org/archives/2011/03/kling_krugman_a.html
    [2] http://research.stlouisfed.org/fred2/series/MULT?cid=25
    [3] http://research.stlouisfed.org/fred2/series/CPIENGNS?cid=9
    [4] http://research.stlouisfed.org/fred2/series/CPILFESL?cid=9

  5. Based on Kling’s liquidity trap discussion, I do believe that we are in a trap. The first requirement being low nominal interest rate, according to the NY Fed, our nominal 1-year rate is lower than average, around .25%. Next requirement is high real interest rates because of low inflation, currently our inflation is low around -.02 meaning our real interest rate is high. From my understanding, this does imply we are in a liquidity trap. With higher real interest rates, consumers would be interested in saving to get a better return, and we would observe less consumption. To fix this trap, the government could attempt a number of policies, expansionary fiscal policy could remedy the low inflation, yet lead to unwanted inflation expectations from the public. Another implication with expansionary fiscal policy is the impact on our debt. High U.S. debt also has a negative impact on the public; if people believe were indebted to other nations, they will have less confidence in our central bank and impact growth. This impact could coincide with further unemployment and less investment. Overall, the implications of expansionary fiscal policy in hopes of getting out of a liquidity trap could impose upon our economic growth.

    http://www.federalreserve.gov/releases/h15/update/
    http://econlog.econlib.org/archives/2011/03/liquidity_traps.html

  6. If the U.S. debases its currency, foreign governments will very likely to react, especially China and Japan who together holds 45.7% of U.S. debt. [1] Debasing the dollar directly takes away other countries’ savings if they have currency reserves in dollars by a significant amount since the situation would be very urgent otherwise other methods should have worked. Debasing one’s currency is a very irresponsible act particularly in the dollar case since it is the reserve currency. If dollar defaults, I don’t think there is any other currency that is ready to replace the dollar yet. Most international business transactions will still be made in U.S. dollars. Other countries will not sit there and do nothing. One possible reaction is to realign their currency to the dollar. In my opinion, if U.S. defaults, China is definitely pegging its currency to the dollar, which if we look from their point of view is a very reasonably thing to do. This may in turn cause a domino effect. Other countries may start pegging their currencies to the dollar for safety purposes and therefore debasing the dollar becomes a meaningless monetary policy. When Japan asked the G7 to help it keeping its Yen low, the G7 helped. I don’t think they will offer the same help for the U.S. just because they cannot pay off their debt.
    [1]http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt

  7. I prefer Krugman’s definition of the liquidity trap that, “The economy is in a liquidity trap when even a zero nominal interest rate isn’t enough to restore full employment,” (1). The liquidity trap has put a constraint on US economic policy. Since the Fed cut the fed funds rate to 25 basis points, the Fed has now gone through two rounds of quantitative easing. Quantitative easing has led to slow economic growth, (the unemployment rate has dropped by 1 percent over the last four months) and firms hoarding money. For example, when AT&T bought T-Mobile they paid for it with $25 billion in cash, that they would have otherwise had on their balance sheet.
    Quantitative easing has also led to inflation expectations. Many economists point to rising food and oil prices at home and in developing countries as a sign for concern. However, I believe this can help us get out of the liquidity trap. By setting a price level target, this will allow inflation expectations to rise. Once our economy starts to grow at a faster rate we can once again begin to slowly raise interest rates and get out of the trap.
    As we saw in late 2010, depreciation of the US dollar doesn’t lead to significant growth, because China is unwilling to allow their currency to appreciate. For that reason, I believe we are going to have to stick with QE2 through June, set a price level path, allow our currency to depreciate as much as possible, use the US government as the borrower of last resort, and have an exit strategy.
    [1] – http://krugman.blogs.nytimes.com/2011/03/18/liquidity-traps-once-again/
    [2] – http://krugman.blogs.nytimes.com/2010/03/17/how-much-of-the-world-is-in-a-liquidity-trap/
    [3] – http://www.economist.com/node/17252006

  8. I think currency debasement is an ideal solution for recovering from a liquidity trap. Obviously, that is easier said than done. Any foreign government is unlikely to be happy with a steep increase in their exchange rate for the dollar. They SHOULD be concerned with the welfare of the US for a variety of economic reasons, namely output, but will not take responsibility for our predicament. As the global reserve currency though, proper political advances could help structure a cumulative acceptance of a debasement. As the assisting question was posed, it sounded as if the US was “demanding” a debasement be allowed (even by countries that have are pegged to the dollar). Instead, a more humble and convincing approach must be taken. A likely scenario would be to map out the intended exchange rate over the future (i.e. large undervalued debasement then a steady appreciation over the next X years) with the desired final exchange rate agreed upon by all the large parties involved. Then other countries would be more receptive to the currency debasement. This action should stimulate aggregate demand, especially exports of American goods. The increased demand for the dollar will yield the appreciation mapped out in the plan.
    http://www.voxeu.org/index.php?q=node/5823
    http://econlog.econlib.org/archives/2011/03/kling_krugman_a.html

  9. Paul Kling states that the textbook definition of a liquidity trap is the point where the economy reaches an infinite elasticity of demand for money [1]. This is interesting because the Federal Reserve Bank of Chicago’s President Charles Evans says that we are in a liquidity trap and that we need “much more” monetary policy in order to get out which seems to be consistent with Kling’s definition [2]. Paul Krugman writes that a liquidity trap is a scenario when even zero interest rates cannot get the economy back to full employment [1]. Again this is consistent with the current economy; projections of unemployment are at about 8 percent and interest rates are nearing zero percent [2]. I think we are in a liquidity trap, but I think the best way to get out of it is not as clear. I think that currency debasement is very risky because if the rest of the world were to sell dollars in fear of debasement it could have negative effects on the U.S. economy. I think a better and less risky method for getting out of a liquidity trap may be to reduce long-term interest rates. This may be an effective way to get out of a liquidity trap and if it does not work then the economy will not suffer much. However, I think that any type of currency debasement or inflation would be drastic and should be used as a last resort. Regardless, some form of policy or commitment is needed to get out of this liquidity trap because expectations are not going to change on their own.
    [1] http://econlog.econlib.org/archives/2011/03/kling_krugman_a.html#
    [2] http://www.businessweek.com/news/2010-10-16/evans-says-u-s-in-liquidity-trap-needs-fed-action.html

  10. Whether it is a “theoretical curiosity” or a practical fact, we are in a liquidity trap. Right now the nominal interest rate is close to zero but it has not been enough to restore full employment. According to the U.S. Bureau of labor and Statistics the unemployment rate is 8.8% [1]. The two quantitative easing(s) as the last resorts and monetary policies of the Fed has not been very effective. Therefore, the other alternative for the Fed is to “manage expectations about the future money supply in states of the world in which interest rates are positive”.
    A continuation of QE through government deficit spending, higher government spending, and foreign exchange interventions will change the expectations about the future money supply. I think such policies only works in the long run. Government deficit spending creates inflationary incentives and the foreign exchange intervention has a similar effect.
    Such policies should change the public’s expectations about future interest rates at the point in time when the zero bound will no longer be binding. In such period, deflationary shocks are expected to decrease. In this situation, the Fed should be able to “commit” to maintaining lower future nominal rates for any given price level. However, I think the public is not trusting government’s commitment, which makes it a huge problem in implementation of government policies [2] [3].

    [1] http://www.bls.gov/
    [2] http://www.newyorkfed.org/research/economists/eggertsson/palgrave.pdf
    [3] http://www.voxeu.org/index.php?q=node/5823

  11. It is my current belief that the United States wheels are stuck in the muddy likes of a liquidity trap, this has become clearer throughout the current state of the economy. The government is having a tough time stimulating the economy and its observable attempts of increasing the money supply with depressing interest rates are not doing the job [3]. While experiencing this virtually zero inflation rates we are not seeing significant decreases in our unemployment rate. Added together these factors are consistent with the common definition of a liquidity trap according to numerous different opinions. Federal Reserve Bank of Chicago President Charles Evans is an avid believer that we are in what he describes as a “bona fide liquidity trap” and believes that much more cautionary measures need to be taken in order to accommodate are current situation [1]. He offers a solution that I find very suitable in order to dig ourselves out of the current turmoil. Well communicated higher inflation rates can promote price stability over an extended period of time. This temporary “inflation targeting” needs to be trusted by the public and the central bank needs to stand by their words and focus on these rates in order to ensure the public’s views. I truly believe that this may be a solution the Fed uses because Ben Bernanke seems to be a big supporter of inflation targeting [2].

    [1] http://online.wsj.com/article/SB10001424052748704706904575556283044368588.html
    [2] http://blogs.wsj.com/marketbeat/2011/04/05/bernanke-increase-in-inflation-will-be-transitory/
    [3] http://research.stlouisfed.org/fred2/series/BASE

  12. As stated by Arnold Kling, there are four ways in which an economy can be experiencing low interest rates and high unemployment simultaneously. One is for an economy to be experiencing a recession that has caused a severe decrease in aggregate demand. Also, interest insensitivity to spending can cause a recession by lowering interests rates to virtually zero percent without stimulating any demand. The last relevant situation in which zero interest rates can prevail is with an economy experiencing infinite elasticity of money demand [1].
    This all leads me to define a liquidity trap in the words of Paul Krugman. That is, “the economy is in a liquidity trap when even a zero nominal interest rate isn’t enough to restore full employment” [1]. Currently the Unites States has experiencing interest rates at virtually zero and unemployment rates fluctuating between 8.5% and just over 10% [2]. Arnold Kling wrote, “the textbook definition of a liquidity trap is an infinite elasticity of the demand for money. The central bank can expand the money supply to an unlimited degree, without affecting interest rates, output, or prices” [1]. While the monetary base (M0) has been steadily rising previous to the 2008 recession, since the beginning of 2008 M0 has more than tripled [4]. All the while, U.S. GDP has continued at its normal 2-3% growth rate after the recessionary years producing the output gap. On another note, the CPI, excluding food and energy, has not seen a substantial increase in the past years following the Fed’s QE [5].
    In conclusion, the U.S. is currently experiencing:
    1. Virtually zero percent short-term borrowing rates,
    2. High unemployment (8-10%),
    3. A large increase in the monetary base,
    4. A minimal reaction/increase in GDP, and
    5. No real reaction in the CPI, less food and energy.
    Together, these variables all point toward a liquidity trap whether you look at the textbook definition or Krugman’s simplified definition. Therefore, I do believe that the United States is currently experiencing a liquidity trap.
    [1] http://econlog.econlib.org/archives/2011/03/kling_krugman_a.html
    [2] http://research.stlouisfed.org/fred2/series/UNRATE
    [3] http://krugman.blogs.nytimes.com/2011/03/18/liquidity-traps-once-again/
    [4] http://research.stlouisfed.org/fred2/series/BASE
    [5] http://research.stlouisfed.org/fred2/series/CPILFESL

  13. The definition of the word liquidity trap is hazy for economists to narrow down due to this crisis being so rare in our society. There is a certainly an emergency at hand in America and we are on track to reach a liquidity trap, but I do not believe we have arrived there yet. The discretionary policy of the Fed allows for monetary improvisation, which is still under being utilized. The Fed has started to purchase $300 billion in long term government securities. The move is aimed at lifting the country out of recession by lowering rates on mortgages and other consumer debt. The Fed will also boost its purchase of mortgage-backed securities to $1.25 trillion. [1] The Fed can and must raise their inflation targets in a credible way so that people start to develop their expectations differently allowing for inflation growth and nominal GDP. The last stage before I believe the economy has reached a liquidity trap is when the US depreciates the currency and still lacks the demand from exports to boast the country back. This country is a Mecca for financial transactions and if the currency is debased we will our respect, strength, and most of all our credibility. The dollar is the standard by which all other currencies compare, and this high demand over the years has been essential to allowing foreign investment and reliance in our economy’s strength. We would be losing much position and value in the world economy if this last resort needed to be enacted. These are all valid alternatives to help restore full employment only time will show if we hit a trap.

    1. http://www.npr.org/templates/story/story.php?storyId=102100052

  14. I disagree with Paul Krugman in that we are currently facing a liquidity trap. Krugman writes that “the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another [1]” I think Krugman is referring to asset swaping with just the money-bonds margin in mind, which line up with his definition narrowly. He negelects to acknowledge that the economy is marginalized in more ways than one i.e. money-goods; that the Fed can operate monetary policy by purchasing longer treasuries and other assets [2]. Even though the nominal interest rate is nearly zero there are still verying levels of higher unemployment which as of recently, has been declining, slowly but surely (which is one of the Fed’s mandates and main reason for QE2)[3]. Assuming that we are in a money-bonds trap, Tyler Cowen writes that “positive aggregate supply shocks tend to be expansionary… they generate income, jobs, and boost real rates of return… it is a slow and painful way to recover and its what we have been doing.[4]”

    [1] http://krugman.blogs.nytimes.com/2009/03/02/a-quick-response-to-scott-sumner/
    [2] http://marginalrevolution.com/marginalrevolution/2010/11/why-i-assign-less-weight-to-the-liquidity-trap-argument.html
    [3] http://research.stlouisfed.org/fred2/series/UNRATE
    [4] http://marginalrevolution.com/marginalrevolution/2011/03/the-subtleties-of-the-liquidity-traps.html

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