Bryan Caplan  

We're Not in a Liquidity Trap

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Mankiw shows two diagrams that many will misinterpret as evidence that we're in a Keynesian liquidity trap.  What's a liquidity trap?  Roughly speaking, it's a situation where monetary policy has no effect on aggregate demand because interest rates are too low or banks are too worried to lend.

One of Mankiw's diagrams shows a vertical jump in the monetary base.  The other shows a vertical jump in excess bank reserves.  In you look closely at the diagrams, however, you'll notice that their scales are different.  The monetary base jumped by over $300B.  Excess reserves jumped by less than $60B.  Contrary to the liquidity trap, the new money is not flying straight into bank vaults and locking the vault door behind it.  Not even close.


P.S. Mankiw sent over a clarification:

FYI:

The latest data on the base is Oct 22.
 
The latest data on the excess reserves is Sept 1.

That could explain the difference.
Who wants to bet on this?  When the excess reserve data for October 22 come out, will the number be over $300B?  $200B?


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COMMENTS (15 to date)
Gary Rogers writes:

I will have to admit that this is one of the mysteries that I am still working on. Where does all that money go that the Fed is pouring into tht money supply?

Ostrich writes:

I don't think you're right on this. Go to the FRB site and look up the current reserve and monetary base report. It shows essentially the same increase in reserves and base. But why wouldn't it? The base is essentially reserves plus currency in circulation plus excess vault cash. Mankiw's charts must have different end dates.

The question is, will those reserves move into lending?

jb writes:

Apparently, the money is going into the banks (like PNC), which are then buying other banks (National City).

Voila - Treasury money becomes a boon (relatively speaking) to the shareholders of National City.

Patrick writes:

Ostrich,

Looking at the St Louis Fed releases, I see the same data as Mankiw's. I also see the differential (~250B) increase in Bank Loans and Leases, so it looks like new loans written.

The increase in reserves looks like a result of interest now paid on those reserves. I guess the Fed wanted to reduce Banks holdings of Treasuries.

Interest Paid seems like a win/win: get Banks out of Treasuries at the bottom of cycles, and provide a competitive riskless return when the economy looks too hot.

Or am I missing something?

Ostrich writes:

Patrick,

I don't know how the St. Louis Fed constructs its charts. Go to
http://www.federalreserve.gov/releases/h3/Current/. I see Sept. 10, Reserves $47+bil, monetary base $844-bil. Oct. 22, 328+ bil and 1143+ bil. I still don't think the relationship between reserves and base means much, unless you are concerned with changing the quantity of greenbacks floating around the economy.

It does appear that bank lending has risen since Sept 10 (they haven't posted the Oct 22 numbers for that yet). I think that's what Caplan is concerned with, so I don't see why he's fussing with the reserve/base relationship.

Acton. writes:

I've always thought that a liquidity trap was something that existed only in Mr Krugman's mind. Recently, that's the only thing that seems to fit in Mr Krugman's noggin.

El Presidente writes:

The liquidity is covering bank losses first; substituting cash for as yet unrealized losses on assets, be it directly or through mergers. If we were not in a liquidity trap, we would have evidence that the money was flowing out of the banks AND into the hands of consumers. Instead, it's scrubbing their balance sheets. They're realizing losses that they would otherwise try to paper over until the whole thing came crashing down around them. This may be a necessary prerequisite to reviving credit markets and thereby strengthening AD, but it will not accomplish that by itself or quickly. It certainly hasn't already. My concern remains: what about any of this stimulus/bailout/stupidity increases the ability of consumers to repay loans, and thereby increases the incentive for banks to lend? We have to change relative income distribution (and/or tax burden distribution) or this problem will not go away.

Ostrich writes:

I'll bet: excess reserves $281,707 million

Jeffrey Rogers Hummel writes:

I'm afraid that with respect to the numbers, Mankiw is closer to the truth than you are. Accurate numbers on bank reserves are devilishly difficult to get and interpret, because the official figures are often adjusted for changes in reserve requirements and do not include excess vault cash, required clearing balances, and Fed float. But you can tease out recent estimates by going to the Fed's weekly H.3, H.4.1, and H.6 releases and by checking against how much of the base increase has ended up as currency in the hands of the general public. Using these means, I put total reserves for the entire banking system (not adjusted for changes in reserve requirements and not seasonally adjusted but counting all vault cash and clearing balances) at $72 billion in August. Currently, as of October 22, total reserves are somewhere between $343 and $358 billion. Notice how close this comes to matching the corresponding increase in the base, from $847 billion to $1,149 billion. The remaining increase constitutes currency in circulation.

But this hardly indicates a liquidity trap, for at least four reasons: (1) Base money can only be held as reserves or currency, and the allocation of a massive base increase between the two tells you absolutely nothing about the overall demand for base money. (2) At the same time that the Fed stomped on the monetary accelerator, it began paying interest on bank deposits at the Fed, obviously increasing the demand for reserves, as I predicted in an email to you. (3) A sudden SHIFT outward in the demand for base money does not in and of itself demonstrate a liquidity trap, as the history of bank panics teaches us. (4) You must allow for lags to see whether this incredibly sudden base increase works its way into the broader monetary aggregates. The year-to-year annual growth rate of M1 has already risen from 0 to over 7 percent, whereas that of M2 is up slightly from 6 to 7 percent.

I will soon be posting more details on the Fed's recent machinations at Liberty & Power.

Bill Woolsey writes:

The "liquidity trap" is a situation where increases in the money supply fail to lower interest rates and/or expand aggregate demand. (The story is generally about interest rates, but the concern is about a transmision mechanism that runs from the money supply through interest rates, to aggregate demand.)

This isn't quite the same thing as an ever decreasing money multiplier so that increases in the monetary base fail to increase the money supply. The limit to that is, more or less, banks holding 100% reserves. (However, banks could hold more than 100% reserves against checkable deposits, so that he M1 money multiplier would be less than one. It is impotant to be careful about what measure of the money supply and what reserve ratio you are considering.

From a policy perspective, I think the only relevant issue is whether aggregate demand remains too low (whatever that would be exactly) even after the central bank has increased the monetary base as much as possible.

For example, open market purchases of government bonds could could increase the monetary base to about 6 trillion. Already, the Federal Reserve has been doing all sorts of direct lending. (The "banks don't want to borrow from the Fed "issue" doesn't seem to be relevant yet.)

So, if the Fed ran out of options for lending and purchased the entire national debt, and still, total spending will not increase, _then_ we are in a policy relevant liquidity trap.

Now, it is possible that there would be ranges over which expansions in the monetary base would not impact expenditure. And, I suppose, one could count that range as being a local "liquidity trap," however, it isn't clear why that is relevant to policy. Just use more heroic open market operations. As long as it is government bonds being pruchased, these are effectively costless and rapid. (Direct lending to bad credit risks is more problematic.)

The lower limit on short term interest rates is negative and is the cost of storing currency

In my view, the U.S. is a long way from having to try anything other than conventional open market purchases of government bonds.

Of course, if interest rates on T-bills turn negative, then fiscal policy, effectively financed by new money creation, makes more sense. Just remember, that after the crisis, when interest rates return to normal, the added national debt would still be there.


El Presidente writes:

Bill Woolsley

Your remarks are very well articulated. Thank you for the clarity and precision.

So, if the Fed ran out of options for lending and purchased the entire national debt, and still, total spending will not increase, _then_ we are in a policy relevant liquidity trap.

Even a blind man can read the handwriting if he gets close enough to the wall. Waiting to get that close instead of using our glasses will cost us time that we won't get back. I would prefer if we didn't do economic analysis by braille. It kinda reminds me of those cartoons where an unsuspecting character is groping their way around the canines of a ferocious beast in the dark before lighting a match and discovering their foe.

The matter of unresponsive aggregate demand, which you correctly identify as the policy concern, is indifferent to cause. The policy response must not be. The sooner we identify WHAT this is, the sooner we will begin trying to understand WHY this is. Waiting until the Fed is out of options doesn't sound like the best course of action to me. That seems like a doctor administering aspirin for a gun shot wound and waiting to see if a patient becomes comatose before considering whether or not they have a life-threatening condition. I'm all for measured responses, but if we wait until we've exhausted one tool we won't have any choice but to use the other and we may have made the problem worse in the mean time. Wouldn't it be better to have both tools to use simultaneously so that neither one has to be used to an extreme?

R Schenk writes:

Excess reserves will be huge. It is not bank lending that matters--it is checkable deposits, and their growth has been small compared to the increase in member bank deposits at the Fed. The Fed is now paying interest on bank reserves, and that interest rate is not much different than what a bank can get with T-bills. In the past there was an opportunity cost for holding excess reserves, but right now it may be insignificant since the T-bill rate is so low. The guess of $281,707 million is probably within $10 billion of the answer. So I will guess $281,708 million.

Bill Woolsey writes:

El Presidente,

You assume that it will take a tremendous amount of time to determine whether open market operatins are unable to prevent depressed aggregate demand.

Very quickly it could be determined whether open market interest rates impact interest rates. (They are...)

Almost as quickly, it could be deterimed whether various meausurs of the money supply are responding.

It is, of course, only GDP figures that take for ever to find out what is happening.

I would just point out, that a "liquidity trap," isn't the same thing as spending not responding to interest rates. Nor is it the same thing as failing to make adequate open market operations because of fear of overshooting.

El Presidente writes:

Bill Woolsey,

You assume that it will take a tremendous amount of time to determine whether open market operations are unable to prevent depressed aggregate demand

That's not really what I'm assuming. I'm assuming rather that we need to stop reacting and get out in front of the market, and that any time wasted places us at least one step behind.

It seems to me that the Fed has lost some of its ability to measure and control the money supply. If we're going to look to monetary policy alone, or first, to address the current problems, then they need to have an accurate measure for and/or tight control of the money supply to effectively and efficiently bring about the outcome they desire. $62T in unmonitored transactions have opened up a gaping hole in the Fed's measure and control of the money supply. Besides, we've run up tremendous debt in recent years and slanted our tax system more in favor of capital and land than labor. Since fewer and fewer people own more and more capital/land, this effectively consolidates wealth and then rewards it with respect to domestic workers and investors. It changes the income flow to persons, since we all remember Cobb-Douglas says it's a fairly stable split between the income of labor and capital. That's what is threatening AD. Credit masked it. Now that the credit has been cut way back, it is emerging. That's why I think there will need to be regulatory and fiscal responses to address this issue well.

I would just point out, that a "liquidity trap," isn't the same thing as spending not responding to interest rates. Nor is it the same thing as failing to make adequate open market operations because of fear of overshooting

I understand and appreciate the technical distinction you are making, and I believe you are correct with regard to the term "liquidity trap" as we have used it in a technical sense. But I think our technical definition has been lacking and I would like us to revise it to more close match the functional definition. We've been focusing only on a special case of a broader phenomenon. It's less about the Fed funds rate and more about aggregate demand and incentives for transaction in the market (the velocity of money and its distribution).

I think you'd agree that fundamental concept of the trap is that owners of money will refuse to lend because they lack sufficient incentive to do so. The Fed can move to reduce interest rates, but the owners will withhold credit in light of the revealed increased risk until rates rise or alternatives dry up. They want more return, not less, and they have the ability to hold out for it, at least for a little while. Handing them more cash does not make them any less likely to do so. The Fed has competition for control, and that won't be solved quickly or easily. I don't think the Fed, all by itself, can reestablish its dominance and adjust the incentives for exchange in the market. Every time there's a rate cut and AD should be stimulated, the liquidity ends up being drawn out of the market and we are left in the same place as we were before the cuts. There's a hole in the bucket and we need to plug it if we want it to hold water well or for any length of time.

Interestingly, the failures in other markets have directed investors back here and have seemingly made them more willing to participate in our market, even at lower returns and with greater risk than existed before. That's like winning by disqualification. If we fail to take advantage of this opportunity to shape up, I wonder if we'll get another chance soon.

John Evans writes:

We and by we I mean America and its satellite states, UK, Australia, Western Europe,etc. We are not in a liquidity trap quite the reverse, this is something new, this is an illiquidity trap. There is no liquidity.
All the banks are bankrupt due to their off balance activities and they all know it. The capital sums lended to them by governments represent only a fraction of their indebtedness. They cannot express this explicitly as this would cause a collapse of the banking system. This truth is expressed in their unwillingless to lend principally to each other but also to anyone else.
This is why the UK government attached the string of retoring lending to 1997 levels to its loans to the banks. The fatal error here being that this was not implemented universally. Some will be obligated, but you can't play poker with half a pack of cards.
Only with huge fiscal stimuli 'gifts' to reduce personal debt substantially is there any chance of resurrecting a velocity to money.
What has been done for the banks has to be replicated on a personal basis.
Regardless we are at the end of an age. I have always considered it extremely short sighted to celebrate the collapse of communism and I was extremely fearful when the Berlin wall came down. Our current economic system has been essentially constituted as an opposition to this 'evil empire' and I wondered in the early 1990's how Islam as the only significant ideological system to threaten capitalism was going to be constituted as an 'enemy'.
Here Hegel has been proved right again, we have had the tragedy of the cold war and the farce of the 'war against terror'
The excess which has bestowed such great benefits on us all and allowed for the financing of a seemingly endless succession of 'foreign wars' has been nothing but the dance of a dervish around the dollar.

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