Arnold Kling  

Liquidity Trapped?

Comment of the Week, 2003-05-0... California Energy Regulation...

The threat of deflation and/or a liquidity trap has been discussed in a number of places recently.

  1. Columnist Robert J. Samuelson writes,

    Global demand remains weak; surplus capacity discourages new investment; gluts depress prices. Deflation could be dangerous: Lower prices could squeeze profits and depress stocks; and lower prices could prevent corporate debtors from repaying loans, leading to defaults and bank failures.

  2. Princeton Professor Paul Krugman explains the basic economic issues, using textbook diagrams or, if you prefer, a four-letter word. In the latter essay, he writes,

    In the 30s and well into the 50s many economists...thought that it was quite possible that a central bank fighting a recession would drive interest rates close to zero, and that any further monetary expansion would simply be stuck away in mattresses or in bank vaults, doing nothing more for the economy.

  3. Reports from the latest Federal Reserve policy meeting suggest that there is a concern with deflation.

    The dollar tumbled on foreign exchanges yesterday as the US Federal Reserve issued a surprise warning that the threat of deflation, or continuously falling prices, is stalking the world's largest economy for the first time since the 1930s.

I recommend some additional background reading. First, there is this discussion paper written by Fed staff economists.

an analysis of Japan’s experience suggests that while deflationary episodes may be difficult to foresee, it should be possible to reduce the chances of their occurring through rapid and substantial policy stimulus. In particular, when inflation and interest rates have fallen close to zero, and the risk of deflation is high, such stimulus should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity...Too much stimulus can be taken back later through a corrective tightening of policies.

Second, there is this speech by Federal Reserve Governor Ben Bernanke.

as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

Bernanke points out that even if the interest rate on Federal Funds reaches a lower bound, the Fed can still lower interest rates in the economy by purchasing long-term bonds or other assets. I view Bernanke's speech as denying that the U.S. can experience a liquidity trap, because in his view monetary expansion can continue to influence interest rates and spending even if the Fed Funds rate falls to zero.

For Discussion. Is the liquidity trap a mere theoretical curiosity or is it a valid concern for policymakers today?

Comments and Sharing

COMMENTS (3 to date)
Eric writes:

Allright all you honest to god degreed economists, answer this question. Isn't the ability to set short term interest rates a largely symbolic power for the Fed? Isn't their real power centered upon buying and selling government bonds, thereby expanding or contracting the money supply?

If so, isn't all this talk of "lower bounds" a bunch of hooey?

Speaking of money supply, it is my understanding (through guys like Larry Kudlow) that the money supply isn't expanding as much as it probably should be. Why?

Yasser writes:

In my view, Bernanke's policy prescriptions will prove to be ineffective.

Long-term yields are at the lowest they've been in decades, yet corporate borrowing is stagnant. The Fed could act to lower long-term yields even further, but spending will remain weak because of structural problems crippling the private sector. Companies are unwilling to invest because they're saddled with excess capacity and heavy debts. Consumers are similarly burdened with heavy debt loads accumulated during the boom. Lower interest rates won't induce a meaningful uptick in spending so long as those structural problems exist. We are in a veritable liquidity trap.

How can the US avoid deflation? The Fed could try to weaken the dollar (although that is already happening), thereby stimulating exports. But I doubt that this, in itself, can be a panacea. With Europe and Japan also facing the specter of deflation, begggar-thy-neighbour policies might become untenable as the ECB and BoJ also opt for the devaluation route. Moreover, dollar devaluation might help stoke deflation given that China pegs its currency to the US dollar.

Another option would be tax cuts - effectively a transfer of funds to the private sector. Consumers and corporations could use the windfall to engage in balance sheet repair, thereby reducing the overhang of debt.

Note to Eric: Much of the expansion in the money supply was a result of robust consumer spending and mortgage lending. Now that consumers are retrenching and the housing sector is cooling, money supply growth has slowed considerably, as one might expect.

randy writes:

The price level answers the question: how much does $1 buy?
Relative value of money falls = prices rise.
Print more money --> relative value of money falls.
End of story, as far as deflation goes.
Interest rate doesn't matter for this purpose.
(In fact, with deflation: an ideal policy is to print money and hand it out to poor people: solves 2 problems at once!)

The real problem is, of course, economic doldrums. But don't confuse the 2 things.

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