Hamilton Scoffs at Deflation and the Liquidity Trap

We can cause inflation without stimulating demand. That would be stupid since we would get most of the bad effects without any of the good effects, but we don't seem to be too averse to the prospect judging by recent government actions. This can be accomplished when Fed rates are approaching zero by parking inordinate sums of new money in banks (because we refuse to distribute it to consumers and the banks do as well). It will not stimulate demand. It will reduce the value of the currency because each unit of currrency will represent a smaller and smaller share of output. This will drive up the cost of imports and services and eventually cascade into other sectors. Combined with stagnant real incomes and and prospectively deep recession, few lenders will be eager to make loans. That's a liquidity trap WITH inflation but WITHOUT stimulating AD. A self-imposed one, but a trap nonetheless.

Worrying about how the Fed can't inflate is like a morbidly obese person with a tape worm worrying that they can't "inflate".

Also, I don't know what these economists are arguing specifically, but perhaps they say "can't" when they mean "not an option". Hamilton's example shows why.

We don't have a liquidity trap though, we have bad investments and the economy needs to restructure. Printing money doesn't help the economy, it further distorts the relative value of scarce goods, labor and capital. Deflation is the cure, why fight it?

Where exactly are people's sense of scale and recognition of scale? What the Fed does, or even can do, in the current situation is minuscule.

People seem to think the Fed - or any current central bank - is the dog that wags the tail. There is a dog, and there is a tail, but it is not the central bank that controls at the present time - the Fed is the tail. The U.S. has something around $55 Trillion debt, of which the Fed has 'control' of less than $12 Trillion.

And the Fed further abrogated its ability to influence, let alone control the 'dog' with its bailout stance. Goldman-Sachs is in a far better position to influence money supply, inflation, the economy and the currency than the Fed is just now. And it is influencing it at every turn.

This argument rests on a simplistic and incomplete view of the money and banking system.

Here is a more intelligent review:

http://globaleconomicanalysis.blogspot.com/2008/04/deflation-in-fiat-regime.html

Perhaps Mr. Hamilton, or Bryan, would like to suggest just how exactly Japan was supposed to prevent deflation in the 90s.

Golden Rule of Economics #23: If any economist says that a particular economic phenomenon is "impossible", that economist is wrong.

Japan's main problems in the 1990s were low productivity, and a legislated decline in the work week between 1988 and 1993 from 44 hours to 40 hours.
http://www.minneapolisfed.org/research/WP/WP607.pdf

As for stopping deflation, no less an authority than Helicopter Ben Bernanke said it could be done by printing up batches of money and throwing them from circling helicopters. No open market operations required.
The reason that Keynesians like Krugman push the liquidity trap is that they want everyone to believe that only fiscal policy alone can cure depressions. That way they can fasten their totalitarian lib. plans over the citizenry, as the government can then pass laws regulating behavior, as the GOoPers did late in the Cheney-Bush dictatorship by forbidding credit card processors from processing gambling transactions. He who pays the piper calls the tune and all.

1. I love 8's comment that

Worrying about how the Fed can't inflate is like a morbidly obese person with a tape worm worrying that they can't "inflate".

2. I would suggest that at least some of the hyperinflation in the Zimbabwe Ruins has been due to the actual destruction of wealth, particularly capital. When you take land and buildings and businesses away from their owners and hand them over to people without any training, ability, experience, or skill at operating them, productivity goes down.

3. My guess is that liquidity traps are an interesting theoretical construct but never encountered in practice. They're mythical creatures like Giffen goods, hen's teeth, naked singularities, magnetic monopoles, natural monopolies, unicorns, virgins, or $20 bills lying on the sidewalk; and if they somehow came into existence in the real world they'd vanish like soap bubbles as soon as anyone noticed. (Like "bygone beasts" and other Reality Deviants in a Mage: The Ascension game...)

mmm...
Typical argument of people talking PAST one another. What you are advocating is just another form of fiscal policy, adopted by the Fed and favouring the already rich, rather than traditional monetary policy. Your just playing with the meaning of words. Your example of Zimbabwian hyper-inflation gives it away.

And besides, if people still expect deflation, that money will STILL just sit in bank accounts. Why should somebody spend money when prices are decreasing? The only I think it might work are the indirect route via an exchange rate fall as people take the cash and invest it overseas. And I should point out that it probably is not possible to buy up all the debt. If people know you are doing it there will be some holdouts waiting for an infinite price.

Generally, irresponsible governments create hyperiflation by combining fisical and monetary policy. They print money and spend it. Or, more exactly, their treasury borrowers money to finance government spending from the central bank, which creates the money the government wants to borrow.

The "liquidity trap" story, is that fiscal policy remains unchanged, and the central bank purchases existing debt. Traditional open market operations, in the U.S., would be for the central bank to purchase short term government bonds.

In the critique, of the liquidity trap cited here, they correctly pointed out that the central bank would, of course, purchase the entire national debt. And then, yes, purchase commercial paper and the like. However, there is a question of credit risk. In theory, the central bank is supposed to be making loans that are paid back.

The helocopter approach is fiscal policy and monetary policy combined. It is like like a tax cut or increase in transfer payments. That is the fiscal policy (and in corrupt irresponsible regimes the transfers go to cronies of the ruler,) but it is being financed by money creation.

Now, I still think the liquidity trap situation is pretty silly.

And, by the way, it isn't the same thing as an increase in the reserve ratio by banks.

A liquidity trap is a real phenomena and anyone who disagrees is currently living on Mars or believing in “assumptions” that have obviously changed.

Hamilton obviously assumes that if the FED goes out and buys up every single outstanding piece of government paper (debt) that it will get lent out again – creating inflation. But what happens if the holders of this newly printed money just deposit it back at the Federal Reserve? No inflation! Money alone does not create inflation, it’s the use/lending of the money in the real economy that does.

A liquidity trap happens when the institutions that are suppose to be supplying credit to the markets are not doing so despite how much money they have – printed or not.

The FED’s next move will be to a zero Federal Funds rate, but anyone who thinks that will change anything is just plain overly optimistic. The FED’s been pumping cash into the system for months and long term rates have been flat or rising. That’s not the sign of inflation that’s the sign of a credit crisis ignoring printing presses in Washington. If the money doesn’t get lent it doesn’t matter how much you print. And now with the economy in full speed reverse, you can’t expect that attitude to change regardless of how fast the printing presses or going (unless you have a massive fiscal stimulus paid for by those presses - sort of a forced lending).

MONEY and WIDGETS
At the basic level the economy is controlled by money and widgets. The government prints the money and everybody else builds widgets. Prices are determined by the ratio of money to widgets. If widgets go up prices go down, if money goes down prices go down. If widgets disappear prices go up, if new money is printed prices go up. Unless money disappears due to unnatural causes, (fire at a bank, a mattress full of cash, Al Capone’s Vault, etc) its normal life goes from printing to generating economic activity to returning to the government in the form of tax where it dies and is replaced by a clone and put back in circulation.

It is not really that hard:
The government prints the money
Everybody else makes widgets
If the widgets get cheaper the government prints more money.
If the widgets get more expensive the government takes money back.
Add a strategic widget reserve so that to the ratio can be adjusted with the numerator or the denominator.
With this simplified system the government only has to worry about defining the average widget, counting them and setting the ratio of money to widgets. Technology can always be used to make sure that the widgets get more abundant and money can be printed accordingly. At the end of the economic cycle they just print what they need and get rid of the unproductive work of the IRS.