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.

From the web site:

Prologue.

Ira Glass speaks with several members of the Planet Money team, who all found themselves—in the course of their reporting—independently asking the same stoner-ish question: What is money? Ira and Planet Money producer Jacob Goldstein discuss a pre-industrial society on the island of Yap that used giant stones as currency.

Act One. The Lie That Saved Brazil.

A trip to a country where the fiction that is money completely fell apart. And in this same country, through a truly incredible piece of policy making, the government tricked a 150,000,000 people into believing their money had value again. Chana Joffe-Walt reports. (16 minutes)

Act Two. Weekend At Bernanke’s.

Though the name of the Federal Reserve includes the word “federal,” it’s not actually part of the government. It’s an independent institution tasked with something very simple, but very huge: Creating money out of thin air. And during this last financial crisis, the leaders of the Fed did things that they would never have considered doing in the past. Alex Blumberg and David Kestenbaum report on what the Fed usually does, and how, since 2008, it’s taken a trip to what amounts to Fed Crazytown. (26 minutes)

Now comes the incredibly difficult climb out of the recession trough. We’ve started climbing, with two successive quarters of positive real GDP growth. The newspapers, cable, talk shows, and blogosphere are filled with opinions, warnings, and predictions. I’m in no position to give a complete prescription for future economic policy, but this is an excellent time for students to be thinking through the issues. They need to separate out the fundamental building blocks of a strong economy and push aside alarmist claims.  Here’s a list of things to think about:

1. Monetary policy and the Federal Reserve: In a mild recession the Fed is our policy instrument of choice. They loosen the money supply, which in turn lowers interests rates a bit, which in turn  helps consumers buy goods and businesses to invest in the future. In the recession that started December 2007, the Fed started with this response but the depth and seriousness of the downturn outstripped the ability of routine monetary policy. They then turned to extraordinary steps to provide stability and liquidity in the financial markets, and have worked to maintain a banking system that will receive deposits from trusting depositors and make loans to worthwhile borrowers. To do this they pumped billions (over a trillion) of dollars into our system.They are now focused on how to retrieve that excess money, so that a more active economy doesn’t use it to spur inflation. They’ve been thinking about this a lot, and Chairman Bernanke insists they will be able to gradually reverse the steps they took, without sending the economy in a tailspin. The Fed also has to decide when to reverse the “normal” monetary policy and started pushing interest rates up. As I see it they are working in kind of a LIFO (last in; first out) order. The most serious and unusual interventions will be corrected first, and then the milder interest rate policies will be corrected as the economy approaches a more normal course.
2. Fiscal Policy and the Congress and Administration: Congress correctly passed a large stimulus spending bill over a year ago. The economy  needed it; routine monetary policy was not going to be sufficient to end the recession; and it would have been political suicide not to take action. The stimulus bill was not perfect. It was probably not large enough. It had some favorite son policy objectives that hindered speedy impact of the spending on the economy, and it had some not very effective tax cuts in order to garner bipartisan support.I’ve learned to appreciate a “prime the pump” analogy for fiscal policy actions like this. If you’ve ever had to use a hand pump you know that sometimes you have to add water in the top in order to get the process working. Government stimulus funds are like priming the pump. They immediately add something to the GDP, since government spending is one component of GDP. The real test of a fiscal stimulus is whether the priming works. In an ideal case, the initial injection of spending prompts a cascading series of new spending decisions in the private sector. This is the essence of what my students learn as the multiplier effect. New spending on roads means more wages for road workers, who hopefully become more likely to spend, and the establishments where those workers spend have the same opportunity. There are plenty of signs that the initial stimulus money started improving GDP. Whether that money has successfully primed the pump is an open question. Some policy experts are calling for more stimulus – a second priming. Others (not including those who object on philosophical grounds to more government spending) worry that another fiscal stimulus would boost the economy just as it is getting better on its own, and could spark an inflationary spiral.There has been a flurry of “job bills” discussed by the administration and Congress. Many of these are responses to a perceived (probably real) concern among the American voter that jobs aren’t coming back quickly enough and something needs to be done about it. I don’t know enough about them to comment thoughtfully. Based on past performance it is easy to guess that some proposals will do little to make a permanent shift in the employment picture, and that some will have serious side effects. One quick example – just about any “Buy American” restrictions will hurt our economy in the long run and have minimal benefits in the short run. The Smoot-Hawley act passed in the early years of the recession is our number one example of the problems of drawing up the bridges and protecting our own workers at the expense of other world markets. On the other hand jobs bills that can reduce structural unemployment through retraining, relocation, and other adaptive strategies are money well spent.
3. Federal Deficit and Debt: This is the trickiest balancing act. It also has the most heat and the least amount of light in media discussions. Here’s what the Congressional Budget Office says about the near term situation:

CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest.

One way to look at this issue is represented by Paul Krugman:

Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment.

Gregory Mankiw is less happy about projected deficits:

The troubling feature of Mr. Obama’s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration’s own numbers, the budget deficit under the president’s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

My own take? Closer to Krugman than Mankiw, but I worry that a partial economic recovery or some call for fiscal stimulus will produce not-well-thought-out-spending plans. These won’t help much, in terms of recovery, they are likely to be persistent beyond the current economic problems, and they won’t help re-establish a deficit closer to 4-5% of GDP.

As a quick review for my students – Our most recent and serious recession came about largely because the prices of real estate and houses accelerated dramatically, and out of proportion to other purchases or investments that the average American could make. When that bubble of high prices popped, financial institutions which had been lulled into thinking their real estate-related investments were safe, found their balance sheets decimated. This has happened several times before in our country’s history, including the technology stock bubble in the late 1990s and 2000, and as far back as the 1800s for railroad properties and precious metals. Even in the 17th century speculation in tulip bulbs caused an economic collapse.

There are two main criticisms about Federal Reserve actions in the last 3-4 years:

1. The Federal Reserve kept short term interest rates too low, for too long a time following the mild recession in 2001. Critics argue that this monetary policy encouraged risky borrowing and unnaturally inflated housing prices.
2. The Federal Reserve was lax in its oversight and regulation of the financial services sector – both over institutions, like banks, and over the risky mortgage lending practices. Regulatory faith in the power of market mechanisms was unearned, and institutions made what we now see as irrational moves.

At a meeting of the American Economic Association in Atlanta this week, Chm. Bernanke rejected the idea that monetary policy caused the housing bubble, but he did acknowledge that weakness in regulatory efforts played a major role.

U of Oregon professor, Mark Thoma, has a nice piece on these issues:

I have been more defensive of the Fed’s actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target.

I’ve gotten on this soapbox before – though the Federal Reserve is a human, fallible organization it is staffed and led by thoughtful professionals and should continue to be protected from political second guessing. There is no member of Congress, including Rep. Barney Frank, who can bring more intellectual and effective knowledge to bear on this issue than Bernanke and his staff.

I am delighted that President Obama has decided to reappoint Ben Bernanke as chairman of the Federal Reserve. While there is certainly room for reasonable people to question some of the specific decisions Ben has made, in general he has led the Federal Reserve System with humility, intelligence, wisdom, and grace.

yeh – what he said…

Chairman Bernanke still faces tough questions in the Senate, which must approve the nomination. There are thoughtful senators who wish the Federal Reserve (mostly under Alan Greenspan) had been less reliant on market forces and tougher on banking and financial regulation. Their points are worth exploring, though with the infamous 20-20 hindsight it is hard to make good policy as a result. There will be other senators who want to score political points, grilling the chairman on his decisions. As Mankiw says, though, Bernanke took on an incredibly dangerous situation, acted aggressively, and by any standard we could impose, made decisions with the best interests of the domestic and international economy in mind. Reasonable people may differ on the margin, but he was a sterling exception to the inaction taking place in Washington during 2008 and early 2009.

Now – for principles of macroeconomics students… The design of the Federal Reserve System – in particular governance and policy making at the national level is supposed to provide political insulation from those policy makers. Each of the seven governors of the Fed are appointed for 14 years. Some may serve longer if they are appointed to complete someone else’s earlier term. That is what happened with Alan Greenspan, who served from 1987 until 2006. Then the chairman and the vice-chairman are each appointed for four year terms. Those terms lie within the overall term of being a governor, and those terms do not sync with the Presidential terms. President Obama will have had a year in office before Chm. Bernanke’s term as chairman is up. The President makes the appointments (governors and chairman and vice-chairman) and the Senate must give its consent. Once appointed a Fed governor and the two main officers may not be removed from office except under exceptional, usually criminal circumstances.

The Fed Board of Governors play an important role in setting monetary and banking policy. Together with the 12 presidents of the Federal Reserve District banks, they set interest rate targets, and other policy interventions. Fortunately, those decisions are generally made on good technical grounds, without much political influence.

There are people who think our monetary policy should be more directly answerable to elected officials – Congress. It is hard to argue that the governors or the 12 district presidents mirror the U.S. population in any way. Those people are financial and economic experts, who are usually fairly wealthy by virtue of their good judgments in the private sector, and women and people of color are usually under-represented among these officials. Yet, since the 1980s with Paul Volker, we have been fortunately to have smart, thoughtful people holding on to this important tiller for the economic ship.

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.

From Economix in today’s New York Times

Economix: Come With Me to the F.O.M.C.: A Sneak Peak Into Fed Life

By Bob McTeer

Published: October 29, 2008

An economist writes about what it was like to be a member of the Federal Open Market Committee and set monetary policy.

But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices. Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices – by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains.

What he is pointing out here is a reminder that our global, electronic system for investments has led to investors buying and selling commodities, like oil and wheat. It is not simply that wheat is grown and sold somewhere to be processed and consumed. Instead, investment organizations buy contracts for the future delivery of these commodities and then hold onto, or sell, or leverage these contracts in order to make money. To do this kind of investment requires credit. Lower interest rates means cheaper credit. And this in turn makes it easier for these investors to hold onto these contracts, waiting for prices to rise further. It becomes self-fulfilling, and meanwhile the commodities don’t get delivered to those who need them.

Feldstein further argues that high commodity prices have a particularly chilling effect on the economy of developing nations, where a high percentage of consumption (and thus GDP) is linked to purchases of these goods. He suggests that those governments then must subsidize purchases or support lower prices, which drains government resources away from longer term, beneficial investments.

We need to keep watching the issue of rising food prices. There are already news reports of riots and political instability driven by rising food costs. Feldstein’s further caution about the opportunity cost of paying for food is important.

The Federal Reserve Open Market Committee (FOMC) is made up of the seven governors of the Federal Reserve System plus the twelve presidents of the district Federal Reserve banks (5 of whom vote at any one time) and executes monetary policy.

They seek to speed up or slow down the economy by influencing short term interest rates. (It is a common misperception that the actions of the FOMC have a direct impact on long term rates, such as those for mortgages. There are some indirect impacts, but generally long term rates are driven by other factors.)

Let’s say that the economy is limping along, with anemic real growth in GDP. Unemployment is starting to inch up, and there are signs of a recession on the near horizon. To correct this malaise the FOMC seeks to lower interest rates. Lower rates encourage more business investment and more consumer purchases. To do this, the Fed needs to pump more money into the domestic economy. A greater money supply will, in the good old tradition of demand and supply, drive price down, which are interest rates in this case. To increase the money supply the FOMC instructs bond traders at the New York district Federal Reserve bank to buy US Treasury bonds held by investors and others. Buying those bonds releases more money into the economy, and lowers interest rates.

If, on the other hand, we are seeing signs of increasing inflation – driven either by increased demand from consumers and businesses, or by increased costs of inputs – then the Fed would like to cool the economy down. They need to spray some water on the hot coals, or to repeat another metaphor used in this case – to take away the punch bowl just as the party is starting to get good. To cool the economy, the Fed seeks to raise interest rates – making borrowing by consumers and businesses a notch more expensive. To raise interest rates, the FOMC will reduce the money supply by selling more U.S. treasury bonds. Those sales (on top of the normal sales of US bonds to pay for the federal government deficit) will take money out of the economy, and push interest rates higher.

So, what is the Fed Funds target rate? It actually represents the interest rate that banks charge each other for very short term (typically overnight) loans. These loans are often made to help banks meet their daily reserve requirements, as set by the regulatory function of the Federal Reserve. These are common transactions, and a necessary accommodation for banks who record millions of dollars in loans and deposits each day, with resulting reserve requirements going up and down, as well.

The FOMC monitors the Fed Funds rate and buys and sells U.S. treasury bonds to keep that rate at the target level.

Now recently there has been separate movement of a different rate – called the discount rate. That rate is what the Federal Reserve charges to loan funds to member banks – again for a short time period. Usually the discount rate is about a percentage point higher than the Fed Funds rate, so this loan capability is not used very often. Also, there is a bit of an informal stigma attached to drawing a loan from the Fed. If we remember that the Federal Reserve has banking regulation as another important part of its charter, going to the Fed for a loan because your bank’s cash reserves are low is a little like going to Dad asking for an advance on your allowance. You may get the money, but not without at least a raised eyebrow.

Let’s talk about the monetary policy choices facing Bernanke. These choices are always present and in conflict with each other, but right now that conflict is front page news and the stock market is on a roller coaster ride as a result.

The Fed has two policy goals. The first is to maintain relatively stable prices in our domestic economy. In other words they seek to keep inflation low – as measured by the consumer price index. Their goal is not zero percent inflation. The Fed seems comfortable with price increases with an annual rate around two percent. They are particularly sensitive to trends in the inflation rate. The second, somewhat subordinate, goal is to maintain a modest growth in our economy as measured by real gross domestic product. The Fed doesn’t publish targets on either inflation or real GDP growth, but for the latter a slowdown below three percent or a heated economy growing upwards of four percent will get their attention.

On Halloween the Federal Reserve Open Market Committee decided to lower the Fed Funds target rate a quarter of a point, to 4.5 percent. (For an explanation of what the Feds Funds target rate is and how it is used see this post.) The important point here is that the FOMC decided that the risk of the economy slumping towards a recession was greater than the risk of higher inflation. In their press release they said, in part..

[The] Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The dilemma – is the housing slow-down and the related credit crunch the more troubling signal in the economy, or are increasing energy and commodity prices indicative of increased inflation? If both, which is the most troubling risk? The FOMC chose to worry first about the risk of recession, and the stock markets reacted positively on November 1. The press release and further reflection by Fed watchers made it seem likely that there will be no further rate cuts – that the inflation concern will rise to the top again. That sent the stock market into a dive on Friday.

Our Federal Reserve Open Market Committee is dominated by bankers. In their souls they fear inflation more than anything else, and when balancing the goals of economic growth and stable prices, they lean a bit towards stable prices. When they choose to boost economic growth, it must mean they are serious.