Wednesday, July 14, 2010

Liqudity Traps are For Real

When I was studying economics, the idea that an economy might face a “liquidity trap” seemed absurd. Basically, the concept of the liquidity trap was that the monetary authorities could not “push on a string”. In other words, the liquidity trap represented a time when the central bank could inject a large amount of reserves into the banking system and people (and businesses) would prefer to hold more money than to hold debt. Thus, funds could not get into the bond market which would mean that businesses would not invest in inventories, plant, or, equipment, and the economy would stay mired at a low rate of activity.

This was why deficit spending on the part of the government was necessary, at least for those following the Keynesian dogma, because it was the only way to increase aggregate demand and re-charge economic activity.

Well, we are in a liquidity trap. The Federal Reserve has injected more than $1.0 trillion of excess reserves into the banking system and has kept short-term interest rates close to zero. And, commercial banks have not lent these excess reserves so they continue to rest on the balance sheets of the banking system. The question is, what needs to be done next?

Furthermore, the government has tried deficit spending to spur on the economy, but this effort seems to have had a less-than-dramatic impact on the economic recovery now seemingly underway. Keynesian dogmatists argue vociferously that the problem is that the government has not spent enough…that the Obama administration has been too timid.

But, this approach to the concept of liquidity traps hinges upon the assumption that the crucial economic relationship is found on the asset side of the balance sheet, on the division of assets between holding money or holding bonds. The analysis completely ignores the liability side of the balance sheet. Nothing is said about the amount of leverage the economic unit has built into its balance sheet. Hence, the issue of whether or not an economic unit has “too much” debt doesn’t even enter the picture. And, this is the problem.

There is an article in the Financial Times this morning that I believe does a good job in addressing this issue. The article is “Leverage Crises are Nature’s Way of Telling Us to Slow Down” by Jamil Baz, Chief Investment Strategist for GLG Partners (

Baz argues that the near-collapse of the world financial system followed by a deep recession was “a crisis of leverage.” The ratio of total debt to gross domestic product in the United States reached 350 percent in 2007. Whereas nations could perhaps maintain a level of 200 percent and still achieve healthy economic growth, the 350 percent figure that remains in the United States (and that also exists at higher levels in many of the leading developed countries) cannot be sustained.

The consequence is that at some time in the future the United States and other developed countries are going to have to deleverage. But, deleveraging is going to be costly in terms of future economic growth. We, in essence, have to pay for the past sins we have committed in building up such an enormous debt structure.

Baz presents “three hard realities we need to bear in mind” that result from having too much leverage. These hard realities are:
  • When you are bankrupt, you either have to default on your debts or you save so you can repay your debts;
  • Policy choices under such circumstances are not appetizing with one school of thought advising taking morphine now followed by cold turkey later and the other school proposing cold turkey now;
  • If you are a politician, you may be under the illusion that you are in charge whereas the real decision-maker is the bond market.

He concludes: “maybe leverage crises are nature’s way of telling us to slow down. Policymakers can ignore this message at their own peril. In their anxiousness to avoid past mistakes, they run the risk of an even bigger mistake: fighting leverage with still more leverage, a strategy that might suitably be dubbed “gambling for resurrection”.

The liquidity trap now being faced by policy makers comes from the liability side of the balance sheet. People and businesses are faced with the choice of either going bankrupt or increasing their savings so as to repay their debts. As Baz says, “This is neither ideology nor economics, simply arithmetics.”

But, it does mean that commercial banks may not want to lend and people and businesses, in aggregate, may not want to borrow. Pushing on a string in this case has little or nothing to do with the asset side of balance sheets and everything to do with the liability side of balance sheets. The Federal Reserve cannot force the commercial banks to lend or people to borrow.

The liquidity trap looked at in this way is real and has been operating for more than a year.

The problem is that if you consider the liquidity trap in this way you can clearly see the dilemma presented by Baz in terms of the policy choices that are currently available. This is why one could argue that it took so long for the Great Depression to end. People and businesses had to work off their debts…they had to go “cold turkey” for a while. In this sense, the economists Irving Fisher and Joseph Schumpeter were closer to understanding the economic situation that existed in the 1930s than was Keynes!

If Baz is correct then the choices are pain now versus more pain in the future. The problems associated with the increased leveraging of the economy cannot be put off forever. Debt must eventually be paid down!


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