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How long will the liquidity trap last?
Is that too silly a question? (And have purveyors of the liquidity trap argument been willing to make predictions?) After all, the TED spread is now below one and there are other pieces of financial good news. If the liquidity trap ends (assuming there was one in the first place), monetary policy will work to stimulate aggregate demand. A big fiscal stimulus won't be necessary.
Will there still be a liquidity trap three months from now? Six months from now? With all those smart people in the White House and at Treasury? What if there is a ten percent chance, each month, that the liquidity trap goes away?
The proposed fiscal stimulus is a big, irreversible investment, which may or may not be needed, and of course it takes some time to get rolling. The traditional economist's recommendation is to apply a very high hurdle rate to such commitments. One alternative is to wait and see if the liquidity trap ends in the near future.
I am not an optimist about the real side of the economy, but I would be surprised if we still were in a liquidity trap one year from now.
Posted by Tyler Cowen on January 14, 2009 at 11:28 AM in Economics | Permalink
Comments
How did the equivalent of the TED spread look in Japan over the last 20 years?
Posted by: Bunbury at Jan 14, 2009 11:40:42 AM
Also, how are we defining a liquidity trap? Is the definition only that the fed funds rate is zero? The Fed can still purchase assets of longer maturity a la Lucas.
As long as those assets have positive interest rates, I don't think fiscal policy is hte only option, although the case for fiscal policy may be somewhat stronger.
I still think we should forget the stimulus and just tell the Fed to purchase the entire national debt until something happens.
Posted by: steve at Jan 14, 2009 11:52:24 AM
Could you recommend your favorite article/chapter/book that most clearly explains the math behind the liquidity trap argument?
Posted by: Ken Hirsh at Jan 14, 2009 12:17:32 PM
Krugman's academic-ish article is pretty good on explaining the liquidity trap.
Posted by: pushmedia1 at Jan 14, 2009 12:35:04 PM
Even if we are in a liquidity trap, why couldn't we inflate rather than stimulate our way out of it? Wasn't that the point of Krugman's baby-sitter parable:
http://www.slate.com/id/1937/
After all, the co-op didn't start hiring baby sitters, it just distributed more tokens. Seems like a good way to keep people from sitting on their money is to convince them that it'll buy less in the future than it does now.
Posted by: Slocum at Jan 14, 2009 12:50:30 PM
@steve
"Also, how are we defining a liquidity trap?"
I thought one of the signs was when folks are
happy to hold either zero-interest-rate Treasury bills or money equally. Time has been erased, in a certain sense? Here several times we have seen people actually prefer to buy T-bills at negative rates, under the assumption that if loss is inevitable no matter what you do, then at least buy an instrument that allows you to know what your loss will be! Is that too casual a way to put it? Maybe.
@Tyler
"I would be surprised if we still were in a liquidity trap one year from now"
I'm not good at math (I can't calculate quickly in my head) but I think the best I am willing to give you for it all being over by this time next year, Jan. 2010 is 50%. To be over in 4 months, I think I'd give 25%; for 95% I may want to say, call me in June 2011. Am I too pessimistic? Will someone check my math? Thanks!
Posted by: StreetWalker at Jan 14, 2009 12:53:00 PM
So theoretically, the TED spread could be lower because banks perceive T-bills to be just as risking as interbank lending. (Right?)
I'm not saying this is happening -- there are clearly other indicators we'd see if that was the case. I just thought it was a interesting way to think about this.
Posted by: JH at Jan 14, 2009 1:04:49 PM
You're missing the political dimension. For Obama, this is a no lose moment. Either he pushes through a giant pork bill and the economy turns up, so he takes credit for saving the world. Or he pushes through a giant pork bill and nothing happens, and he says, "Think how much worse it would have been."
In either case, a man who has been obsessed with obtain personal political power since his mother indoctrinated him in that as the highest ambition back in Indonesia in the 1960s, gets to spend vast amounts of money to reward his supporters.
Posted by: Steve Sailer at Jan 14, 2009 1:31:57 PM
Steve Sailer is dead on. At least with his first paragraph.
All other things being equal, grand spending projects which are visible and accessible to the taxpayers are infinitely more politically sexy than a Board of Governors meeting on C-SPAN (do they even televise them?)
Posted by: Economic Geography at Jan 14, 2009 1:50:37 PM
It's important to remember that Obama didn't run for President because he has a strong interest in macroeconomics. He chose, out of all the opportunities in the world available to him, to become a Chicago politician. So, if you want to understand his perspective, you have to understand the men he has studied as role models: Harold Washington and the Daleys.
You have to remember that Obama's prime goal in life all the way up until his career plan was derailed by his soul-crushing rejection by black voters in his 2000 Democratic House primary run was to be Mayor of Chicago, because that, as he often said, is where the power is. He never showed any enthusiasm for reforming Chicago politics, just for winning at Chicago politics.
And one way you stay in power in Chicago as mayor is you build big things. Richard J. Daley always asked his advisers: What can I get built before the next election?
Posted by: Steve Sailer at Jan 14, 2009 2:22:26 PM
Heil Sailer!
Posted by: steve at Jan 14, 2009 3:30:08 PM
Sailer,
Just what is the evidence of your various contradictory
assertions about Obama? On the one hand you have him obsessed
since his indoctrination in Indonesia as a child by his mother
with becoming president. Then you have him only focused on becoming
Mayor of Chicago, until his "soul-crushing" defeat in 2000. Which
is it? Your credibility is looking worse than usual.
As someone who knows a lot of people in Chicago, including friends
of the Daleys, I would note that you have a stronger case for your
first assertion, with this apparently having been fine all along
with the Chicago Machine. Their view is reportedly that whenever a
goody goody type with lots of charisma and potential power like
Obama comes along, they want him out of town as soon as possible
where that charisma and power potential can be used on behalf of
Chicago without messing up their little internal games. Hence, off
he went to Springfield first. His supposed "soul-crushing" defeat
was for a House of Representatives seat in Washington, not exactly
the obvious sprinboard for becoming Mayor of Chicago. Sheesh.
Posted by: Barkley Rosser at Jan 14, 2009 3:57:14 PM
Barkley Rosser:
"His supposed "soul-crushing" defeat
was for a House of Representatives seat in Washington, not exactly
the obvious sprinboard for becoming Mayor of Chicago. Sheesh."
By running for the House, Obama was attempting to follow the career path of his hero, Harold Washington, who went from the state legislature to the House of Representatives to the Mayor's Office.
For Obama's obsession with getting elected mayor of Chicago, see Bill Mundell's biography of him, which mentions how often he told his Harvard Law School classmates that he was going back to Chicago to follow in Harold's footsteps and get elected mayor, because that job has real power.
As for his defeat in 2000 being soul-crushing, read Obama's account of how down he was for the following year in "The Audacity of Hope."
For his mother's indoctrination of him during her spats with her unsatisfactory second husband in Indonesia in following in his biological father's footsteps of becoming a political leader of the black race, see Obama's "Dreams from My Father: A Story of Race and Inheritance."
Posted by: Steve Sailer at Jan 14, 2009 4:34:22 PM
Dear Dr. Rosser:
Also, you misread what I say: His mother didn't indoctrinate him in becoming President, but in becoming a political leader who would fight for the black race, in the manner of his father. Harold Washington, the first black mayor of Chicago, was Obama's role model up through his rejection by black voters in 2000 as not being black enough compared to the ex-Black Panther Bobby Rush.
In "Dreams from My Father: A Story of Race and Inheritance," Obama describes his job interview in NYC for the community organizer job he took in Chicago:
“What do you know about Chicago anyway?” …
“America’s most segregated city,” I said. “A black man, Harold Washington, was just elected mayor, and white people don’t like it.”
“So you’ve been following Harold’s career,” Marty said. “I‘m surprised you haven’t gone to work for him.”
“I tried. His office didn’t write back.” [pp. 141-142]
As Obama told the Chicago Reader in 2000, the reason he had returned to Chicago from Harvard Law School is that, “if you’re interested not only in politics in general, but interested in the future of the African-American community, then Chicago in many ways is the capital of the African-American community in the country.”
In short, the President-Elect wrote a 460-page autobiography in 1995 that profoundly contradicts the public image as the post-racial transcender that David Axelrod whipped up for the media after Obama's goal of becoming a black political leader in the Harold Washington mode was stymied in 2000 by his defeat by Bobby Rush. But not many people have read Obama's autobiography carefully.
Posted by: Steve Sailer at Jan 14, 2009 4:45:28 PM
Like black holes in physics, liquidity traps have a strange beauty. Until recently most economists saw the concept as tangential to mainstream macro, however Friedman and Hicks correctly placed it at the center of (old) Keynesian economics. Tyler Cowen says "If the liquidity trap ends . . . monetary policy will serve to stimulate aggregate demand." One could easily reverse the causation; perhaps only a monetary policy that stimulates AD can end the liquidity trap. It is quite likely that when the liquidity trap ends (if by liquidity trap you mean zero short term rates) it will be because the Fed has tightened policy to restrain excessive growth in AD. If we wait for the liquidity trap to end before an expansionary monetary policy can get traction, we may be in for a long wait. The Fed needs to spend less time on bank bailouts and more time reversing deflationary expectations (there a lots of proposals out there about how to do this.)
Zero interest rates are often seen as indicators of a highly expansionary monetary policy, but in another sense they are the result of monetary policy that is far too contractionary relative to the needs of the economy--so contractionary that deflationary expectations have set in. Krugman's right that liquidity traps are better viewed as expectations traps. But even the "trap" metaphor is inappropriate, as (contrary to Krugman) determined central banks can always create inflation expectations, and hence can always depress real rates when nominal rates are stuck at zero. Japan has experienced 14 straight years of mild deflation (in the GDP deflator.) During that period the BOJ tightened policy twice. Krugman argues that the BOJ was unable to convince the markets that they wanted to inflate--but their actions suggest they got exactly the mild deflation they wanted. Let's hope the Fed doesn't make the same mistake.
Posted by: Scott Sumner at Jan 14, 2009 6:02:53 PM
If the liquidity trap ends (assuming there was one in the first place), monetary policy will work to stimulate aggregate demand.
Not to mention the CPI. My prediction is that within a year our current worries about deflation will be hilarious.
Posted by: Bob Murphy at Jan 14, 2009 7:25:47 PM
Liquidity trap means that people are very uncertain about the future or they see few good investment oportunities.
Perhaps many are holding their breath till they see if Obama is a Social Democrat. So far he wants to be the biggest spending President in history and he will be leaving massive tax increases for the future. Not to mention a drop in the value of the dollar, with increasing inflation and taxes in the future.
Plus the threat that if you are lucky enough to turn a profit you become public enemy number one. What they don't tax while you are alive they will take at your death bed.
We have people in power who are anti-business, pro-regulation, favor increasing taxes and you wonder why we have a liquidity trap i.e. a view that investors have few good options with their money
Posted by: DanC at Jan 14, 2009 8:09:09 PM
why would banks loan to anyone given that any collateral posted for the loan would be worth nominally less in a year than now?
Posted by: babar at Jan 14, 2009 9:01:20 PM
Steve Sailer,
OK, fair enough. You have provided some evidence for some of your claims.
Even if what you say is true, so what? Nobody who was running for president
was expecting to have to deal with a major financial collapse and recession.
And, when Washington first won in Chicago, many thought he might reform Chicago
politics, even if later it became clear that this was really just a switch from
one group running the machine to another. Even if one wants to say it was due to
his being beaten by Bobby Rush, do you think that Obama is now a phoney when he
presents himself as a post-racial healer?
A joke about Chicago politics, which I think I have put up here before. This dates
from the period after the Kennedy election in 1960, which some attributed to vote
manipulations in Chicago that gave Illinois to JKF.
So, JFK, RFK, and (the first) Mayor Daley are all stranded on a lifeboat. They realize
that there only enough supplies for one person to survive. So, they decide to have an
election to see who it will be. Each gives a speech. JFK says, "Vote for me, I am the
Leader of the Free World." RFK says "Vote for me. I am the Attorney General, who enforces
the laws in the United States." Mayor Daley says "Vote for me. I am the mayor of the city
that works." In the end, Mayor Daley won, 7-2.
As for the liquidity trap, it is not as trappy as it seems, given that we have seen negative
nominal interest rates.
Posted by: Barkley Rosser at Jan 14, 2009 11:20:07 PM
I'm not even sure we are in a liquidity trap. The real problem is, to quote Thurman Arnold, "It means that an incredibly rich country can find no ideological way of providing its citizens with the standard of living it is physically capable of giving them." He was the one who accepted that Americans would not climb trees and throw coconuts at each other if the banks closed in 1933.
We can lower interest rates as much as we want, but without consumer cash flow and confidence that this cash flow will continue, we can't expect consumers to borrow and spend. Without consumers willing to borrow and spend, we can't expect investors to invest in inventory and productive capacity. Only a government would be stupid enough to spend when it has no idea of where its next dollar is coming from or to invest when no one can afford to buy its products.
As in bridge, the economy sometimes need a designated dummy.
Posted by: Kaleberg at Jan 15, 2009 9:14:51 PM
Dear Dr. Rosser:
My view on Obama is that the new President has put a lot of effort into writing two books, a 1995 autobiography and a 2006 campaign book. The problem is that the 1995 autobiography, when read carefully, sharply contradicts the entire "post-racial healer" campaign narrative he's been running on in the 2000s. "Dreams from My Father" turns out to be exactly and obsessively what it subtitle says it is: a 460 page "Story of Race and Inheritance" documenting Obama's 25-year-struggle to prove himself "black enough" to fulfill the dreams from his father (as transmitted by his mother) of becoming a political leader who would use his power for the black race.
It's quite possible that Obama changed his ambitions after black voters rejected him in 2000 for not being black enough, but Obama wrote in 2004 that he wouldn't change his 1995 book other than to shorten it. So, perhaps his current image is just a concoction invented by David Axelrod to appeal to white voters.
Who knows. The real problem is that _nobody asked Obama_ about the contradictions between the two books.
Posted by: Steve Sailer at Jan 16, 2009 4:00:55 PM
