Liquidity Trap

Was it Popeye’s friend, Wimpy, who kept asking for a hamburger on credit? Today’s credit markets are anything but robust, with reduced demand and supply for borrowed funds. Always eager to find obscure terms for modern dilemmas, economists refer to this condition as a liquidity trap. With a little prodding from Facebook friend and neighbor, Patrick, we’ll give the concept a once over.

Jumping to the conclusion (and resisting the academic approach of a slow, careful warm-up) there is bad news and good news about liquidity traps. The bad news is that they make it difficult for the Federal Reserve to execute monetary policy. Creating 100s of billions of dollars has a muted impact on our economic recovery. The good news is that the liquidity trap dampens the significant inflation we might expect with the creation of all that money.

OK, back to the beginning. During times of slow or no growth and high unemployment the Federal Reserve can create/inject money, largely by increasing reserves that banks have in their accounts with the Fed. They can do this by buying U.S. treasury bonds on the open market, or even by buying troubled/toxic assets from banks. This increase in the supply of money allows interest rates to fall, which in term spurs demand for more consumption and investment. This is classic monetary policy. With mild downturns this is often enough to increase growth and kick start the economy. For the most recent 2007-2009 recession the Fed took these actions, a number of times in a number of ways, and those actions were not sufficient. Now the target short term interest rate – the Fed Funds rate – is essentially at zero. The Fed can’t lower the interest rates any further. Here’s a graph of the Fed Funds rate since 1980. The big peak at the beginning of the graph was the result of aggressive Fed action to contain inflation. Now, though, the rate has sunk to the very floor.

Fed Funds Rate - St. Louis FRED database

One thing that is happening is that while reserves are building up in our financial system, the banks are holding on to them rather than increasing their lending. Some argue that the banks are using the added funds to improve their balance sheets, which were hurt by the dramatic loss in value of securitized mortgages and other derivative assets, and to build up enough cash to pay executive bonuses. The banks argue that demand for credit by qualified borrowers is low. I don’t put much credence in the latter explanation.  One apt analogy for this situation is that the Fed is trying to push on the end of a string, in order to get the economy going.

There is another layer to the liquidity trap concept, and that has to do with the buying public’s (people and business) expectation for inflation. The theory goes that if buyers expect inflation in the future, they will increase buying now. They expect the value of their cash or savings to go down during inflationary times, so they seek to use it now, while its value is still high. This works with traditional monetary policy where an injection of money would be expected to increase inflationary pressures.

On the other hand if purchasers believe that inflation will be controlled, then there is less pressure to buy now. That’s what is happening now. Despite what some politicians suggest, inflation is not right around the corner, and buyers are in no hurry to convert their cash into goods. We see evidence of this with the continuing low interest rates on U.S. bonds. Expectations of high inflation would push those interest rates up. Low inflation expectations, even in the face of increasing money supply is another symptom of a liquidity trap.

This scenario played out, to grim effect, in Japan in the 1990s, as their central bank poured money into the banking system and no one responded. Their “lost decade” was one of almost zero growth.

This paper by a New York Federal Reserve staff economist explains things in more detail, complete with impenetrable equations.

Pundits and observers, who are no smarter than you or me, are assuming that Greece will default on its sovereign debt. This is as if the United States decided not to pay off our U.S. bonds one day.

To avoid a total market meltdown, the “grownups” in the European community would probably insist that the private banks holding Greek bonds accept cents on the euro. If Greece owes me $100 on a bond I purchased last year, I would only receive $45.

Haircut for Greece Creditors?

The term of art for this reduction in the payoff is a haircut. Lots of figures rattling around the news sphere. I’ve seen suggestions/estimates of a write down of 30 to 60%. That qualifies as a buzz cut.

Greece Flag

So, who cares about the Greek debt crisis? It’s a small country, a long ways away.

Answers:

Greece as a Country: “We care!”

The Euro currency countries: “We care!”

Europe Generally: “We care!”

U.S. and International Financial Community: “We care!”

Stock Investors: “We care!”

All right, already.  Here’s why they care.

The background

Through a series of missteps over the last 10 years the Greece government amassed a large government (or sovereign) debt, and then disguised it from its citizens, lending institutions, its Euro partners, and international financial organizations. The recession exacerbated the problem, threatening to push the Greece government into bankruptcy. Annual deficits as a percent of GDP or total national debt as a percent of GDP are higher but not that different from the United States, but in contrast to the U.S. the global investment community has very little confidence in Greek bonds and the ability of the government to repay them. That means Greece has to pay much higher interest rates on its debt, if it can borrow money at all.

What Can Greece Do?

When faced with larger government deficits, policy makers typically turn to two economic “levers” – fiscal policy and monetary policy. On the fiscal side the government can cut spending and/or raise taxes. Both of these actions have met strong resistance in a country used to heavy subsidies of middle class citizens and notoriously poor tax collection records.

Monetary policy can be an effective tool – often because it does not require the approval of the legislature or the voters. Normally a central bank can inject funds into the economy (electronically “printing” money) and use that to pay debts. This injection of money can also lead to the devaluation of the local currency. While devaluing doesn’t sound appetizing it can be very effective, since it encourages more exports and more tax revenues, and because it makes it easier to pay off debts denominated in the local currency.

BUT, Greece can’t execute its own monetary policy. It is a member of the Eurozone – using the Euro as its currency rather than the drachma. As a result Greece cannot unilaterally change the supply of its currency. It does not have control over monetary policy. To make matters worse for Greece, the Euro has held a fairly high value against other world currencies – just opposite of the direction Greece needs to help with its problems.

Euro

How Does the Crisis Affect the Euro?

The Euro is a common currency, currently used by 22 European countries. Decisions on the supply of the Euro are made by a representative body at the European Central Bank.

When a member country, like Greece, threatens to default on its loans, global investors pull funds out of Greece and the Eurozone. This reduces the demand for euros, and causes the value of the euro to fall. This is a mixed blessing. Countries often prefer a strong currency, but a weaker one can encourage exports. Europe is an export driven continent.

Joining the Eurozone initially, countries have to prove that their economies and government budgets are healthy. It is like welcoming someone new onto a lifeboat. You prefer the new person to be healthy. It appears that Greece hid or obscured its economic reports when applying for membership and now its fellow lifeboat members are not happy.

Commentators, such as Paul Krugman, have argued that Greece should never have been allowed in the Eurozone. They also argue that the Euro common currency is flawed if monetary policy is directed centrally, but fiscal policy remains with individual countries. Macroeconomic theory suggests that both need to work in concert, and the slow, deliberative and political style of the European Central Bank is not well suited to crisis management. Here’s one of many Krugman posts on the crisis.

Why the Large Bailouts by European Governments?

Other European countries, particularly those who share the use of the euro currency, want to stabilize the currency in their own self-interest. In addition many of the large banks and financial institutions in Europe hold Greek debt. If Greece defaults on that debt, those institutions are in trouble. France and Germany have been two of the largest contributors. French voters have been relatively quiet about the bailout, but German politics are much more sensitive to the issue. Chancellor Merkel of Germany has to balance the need to preserve the Eurozone economy against the indignation of German taxpayers who feel little affection for Greece.

European policymakers also worry about other members of the Eurozone – including Spain and Ireland. These two countries have stressed economies for reasons different than Greece. Neither of them had profligate government spending, but both have been hit particularly hard by the recession. Additional stresses on Europe could tip these countries further into trouble.

Why the International Community and Stock Investors Worry

The source of concern in the stock markets and among international investors is mostly fear of default. Large financial institutions and other holders of Greek debt would be seriously hurt. If a Greek default pushed other European countries like Spain and Ireland over, the impact grows significantly.

In my Principles of Macroeconomics class we have just been talking about money (in particular fiat money) and the importance of trust. As long as economic players trust that money will be valued by others we use it. The same kind of trust is important in banking. Our economy needs banks in order to attract deposits, which then allow borrowers to secure loans and invest or consume.

The FDIC is a type of insurance program for banks. Each bank is required to pay premiums to the FDIC. If that bank fails, then the bank’s depositors are protected and will get up to $250,000 from the FDIC. This protection made wary depositors in 1933 start returning their money to the banks, which in turn helped fuel the recovery.

On NPR’s Morning Edition this morning, there was an interesting piece about workers hired by the FDIC in 2009 to help with the process of closing failed banks, securing the deposits and paying the depositors, and then selling the remaining assets of the bank. As of now there isn’t a transcript of the piece, but you can listen to it here.

I get asked this question a lot lately. First, despite the inference of the video provided by the Bureau and Engraving and Printing (see below), the Fed has not been running the money printing presses for extra shifts in the past few months. Instead the Fed can buy U.S. Treasury bills on the open market, and can find a number of other ways to pump money into the economy. The way the money gets created is that the Fed credits the account of securities dealers, banks, and other institutions – each of which have accounts at various Fed district banks. So the balance on these accounts is higher, which gives banks in particular the freedom to lend out more more or somehow make use of the cash. And when the Fed and other policy folk measure the amount of money in circulation they count not only hard currency, but also the balances in checking and other demand deposit accounts.

So, now that we know that money isn’t really being printed, we still need to be concerned by the significant increase in money (represented by currency and checking account balances) injected by the Fed. The inflation concern is real and important. It is a concern not lost on Federal Reserve officials. There is no question that in normal times a significant increase in the money supply usually leads to inflation.

This article in today’s Wall Street Journal explains what has been happening, and also describes how the Federal Reserve will be able to bring back much of that money as the economy improves.

‘We are thinking carefully about these issues,’ Mr. Bernanke said in a speech in Atlanta last week. ‘Indeed, they have occupied a significant portion of recent [Federal Open Market Committee] meetings.’

Ideally the Fed will “reel in” the money in a manner that avoids inflation while not prompting another downturn. Reducing the supply of money generally means higher interest rates and a dampening of economic activity. You’ll see in the article that Federal Reserve officials are thinking a lot about this issue right now. You’ll also see some cautionary opinions from others who are skeptical that the Fed will be able to get the timing right. These critics worry that the Fed, for a variety of reasons, will be slow to turn off the money spigot and turn on the money vacuum. If they are slow, inflation can catch on and that is hard to stop or control.

So, when I’m asking about the risks of inflation due to all of this money printing, I agree with the inflation concern, but express my hope and confidence that Fed officials have thought this through and will reduce the money supply at just the right moment.

Liquidity / Credit Crisis: The main cloud hanging over our economy at the moment is the inability, or more accurately, the unwillingness of banks and other financial institutions to loan money – hence the label “credit crisis”. This has happened for a number of reasons. I’ll mention a couple.

1. Banks and other financial companies saw their assets disappear in rapid, unexpected fashion. As we’ve learned throughout the year, many financial institutions had been buying, for investment purposes, securities made up of mortgages on people’s homes. A couple of years ago these packages of 1000s of mortgages were judged to be quite safe. Even if a percentage of those mortgages went into foreclosure, the rest would be fine and the whole package would be fine. However, when the housing price bubble burst and when some loans with very low interest rates and monthly payments reverted to more normal levels, the rate of foreclosures escalated. Now those packages of mortgages started looking less safe, and banks and others started trying to sell them and bail out. Those packages were recorded on the banks’ books with a certain value, but that value started plummeting, as it got harder to find buyers for these packages. Banks started seeing their net worth disappear overnight, and that in turn put many of them in jeopardy of default. There is a side issue here about how forthcoming companies should be in reporting the drop in value of these assets. It is called “mark to market.” Here’s a little write up about it.

2. Lenders, taking a peek in the mirror, started losing trust in their borrowers. Many of the same banks that were suffering problems were less likely to loan out money – not just because they were in trouble themselves, but also because they worried about the credit worthiness of the banks, businesses, and other institutions who were looking for loans. Vikas Bajaj wrote about this in today’s New York Times – about how fear seems to be overtaking logic and normal market forces right now.
3. We’re being reminded of how much our economic system, and day-to-day business relies on easy credit. None of this is new, but this crisis has brought out into the open the traditional practice of businesses (large and small), banks, and other financial organizations to borrow money to cover short term demands for cash, and then repaying that loan shortly. They do it to buy inventory, meet a payroll day, take advantage of low prices, or to just make other investments with someone else’s money.

What is the U.S. government doing? Lots of things, many of which I don’t really understand or can keep track of. There are a couple of major activities that I can try to comment on:

1. “The bailout.” The final bill passed by Congress was larded with all sorts of things to buy the necessary votes, but the essential piece was giving the Treasury Department authority to buy some of those hard-to-value mortgage packages. This should have two beneficial effects. First, banks and institutions that sell these to Treasury get cash, which helps their own balance sheet. Second, this starts establishing a market price or value on these packages. The lack of a commonly agreed upon price or value has made it impossible to establish a market and to get these securities moving again.

2. Flinging open the discount window. Traditionally the Federal Reserve Bank, acting as the “banks’ bank” has had a lending facility for banks called the discount window. Banks experiencing temporary hard times could borrow money from the Fed at fairly reasonable rates, for short periods of time. In normal circumstances this is not used much, because the loan from the Fed also raises eyebrows from the Fed’s own bank regulators. I describe it like going to Dad to ask for an advance on your allowance – you can get the money, but you open yourself up to disapproving questions. This year the Fed has taken a number of steps to encourage banks to use this borrowing option, and has allowed financial institutions other than commercial banks to make use of it. This provides more credit and liquidity in a market where there is a shortage of both.
3. Reducing short term interest rates. The Fed announced today that it was lowering the Federal Funds target interest rate by one-half a percentage point – from 2.0 to 1.5. They announced this in concert with a number of other large countries and their central banks. This is a classic exercise of monetary policy, with the Federal Open Market Committee releasing funds into the market in order to drive short term interest rates lower. This doesn’t have a direct impact on mortgage interest rates, but is designed to help stimulate the economy, encourage more borrowing, and more consumption.

So will all these steps work? We hope so, but it is hard to tell. We’re in uncharted waters. When people ask I tell them that I’m comforted by having a Federal Reserve Chairman, Ben Bernanke, whose academic specialty as an economist was the study of the Great Depression. He’s done some of the most important work on understanding how we got into the Depression, the actions the government took (for better or for worse), and how various countries emerged from the Depression years later. Still it is a much more complicated world we live in today. I’m just relieved to have a super smart, thoughtful person in that seat, rather than a “helluva job, Brownie.”

Stock market results are discouraging, but they are not the best barometer of how things are going. They are influenced by a sort of herd mentality and investor concerns. What we want to hear is whether banks are starting to lend to one another, that companies can find buyers for short term commercial paper in order to finance their day to day operations, and that financial organizations are looking beyond their mirrors and considering how to make money by lending to others.