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.