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.

In his Nobel Prize speech this past Thursday, 2011 laureate Thomas Sargent made a very interesting link between the multi-country crisis in Europe and a similar situation in America’s infancy, bringing together 13 independent states. The speech itself is oddly uninspiring, and starts with some of the math for which Sargent was recognized in being award the Nobel Prize, but you can watch it here for extra gems I may have missed.

Original 13 States

Sargent noted that the new American country faced an economic crisis in the late 1780s. The first U.S. Constitution, the Articles of Confederation, left the original 13 states largely independent, with a weak, and poor Federal Government. The states and the Federal government had collective debts totaling over 40% of GDP. The 14 different governments found that investors were very skeptical of government bonds, which meant very high interest rates, and those bonds being sold in the secondary market for deep discounts. (Jump forward to 2011 to a nearly identical problem faced by the European countries.) Sargent’s observation; “Fiscal crises often produce political revolution.” This was apparent in 1787 as the United States lurched into an uncertain future.

Alexander Hamilton

Alexander Hamilton, a 32 year old Secretary of the Treasury, joined President Washington and other founding fathers in framing a new, more permanent U.S. Constitution. As part of this legal realignment, Hamilton proposed a solution to these lingering, expensive debts:

• The Federal government would assume all of the states’ debts (i.e. a bailout.)
• All trade and most fiscal policies would be centralized in the Federal government.
• The Federal government would have an enhanced ability to tax.
• There was essentially no monetary policy at the moment. The U.S. minted a silver dollar – similar to other silver pieces minted in Europe. Its value was tied to the value of silver. In essence the U.S. was on a silver standard for the first decades of its existence.

Sargent noted the results of Hamilton’s moves:

• The creditors, who held the old bonds, were kept whole and rewarded the new Federal government with more lending capacity.
• The government bonds were no longer sold at a discount, and interest rates fell to manageable levels.
• There was increased liquidity – i.e. improved availability of credit for businesses and government
• The Federal government enjoyed significantly greater tax revenues.
• Not right away, but eventually the Federal government signaled that it would no longer bail out state or local governments for their debts, and in quick succession, states passed balanced budget amendments to their state constitutions.

For history buffs, Hamilton’s first report to Congress, on public credit is an interesting read.

Europe

Now, let’s make the links to the European debt crisis. For a variety of reasons many European governments are faced with the same challenges as the fledging United States in the 1780s. Some countries, most notably Greece, mismanaged their fiscal policies, with generous government spending and lackluster tax collection. Some countries rode the surf wave of the financial bubble, allowing local banks and sometimes sovereign funds to speculate heavily. (Ireland comes to mind here.) Others, like Spain, are almost innocent bystanders with modest debt but heavily hit by the housing/credit crisis. All of these countries face investor skepticism towards their sovereign debt, which means they need to pay high interest rates if anyone is interested in buying their bonds.

As we have discussed in an earlier post, the countries who share the Euro currency have no independent monetary policy. That power is held by the European Central Bank which has been reluctant to be a lender of last resort or the source of monetary stimulus. Germany, as the strongest economy on the continent, and to some extent France, have struggled with the question of bailouts to troubled countries, maintenance of the Eurozone community, and their own political concerns at home.

Angela Merkel

In a marathon negotiating session this past week, German Chancellor Angela Merkel drove a resolution to this crisis which involves greater fiscal policy discipline and coordination among the European countries, and the strengthening of a multi-national lending fund to help struggling countries. As an interesting side note Great Britain, which has been a party of past European treaties but did not join the Euro currency, rejected the new treaty and will be on its own.

In his Noble speech, Sargent left the conclusions to his audience. Are we seeing Europe following the path of the original 13 states of the U.S. in the formation of a much more centralized Europe? Will the global investment community reward this action with lower interest rates on European debt? Will the member countries change their behavior, with the example of bailouts fresh in their memory?

I get little news snippets sent to me, via email, from the Wall Street Journal. Here’s one that arrived this morning.

The 10-year Treasury yield, the benchmark for U.S. consumer and corporate borrowing, rose to 4% for the first time since June.

The move extends a steady increase by Treasury yields, which move inversely to prices, lifted by a combination of stronger economic data and the barrage of debt issued by the government to meet its financing needs. Recent Treasury auctions have met with much weaker demand and Monday’s move comes ahead of more auctions this week, with the Treasury Department set to sell $82 billion of Treasury notes and bonds.

The 10-year yield is a key benchmark for mortgage rates and other consumer and corporate lending.

“So, what does this mean?” you say. I’m so glad you asked…

Someone can buy a U.S. treasury bond, for something like $1,000. Let’s say you buy one that matures in 10 years. Over the life of the bond you will receive interest on your “loan” that is set when you first purchase it. Now along the way you can decide to sell the bond to someone else.

If today’s interest rates are exactly what they were when you bought the bond, then the fair price for the bond is $1,000.  However, if interest rates have gone up, then your bond is delivering less interest than someone could get by buying a new bond at the higher rates. So, to sell the bond you need to reduce or discount the price. Someone might be willing to pay $950 for your bond, receive lower interest for the remaining years, and then get the original $1,000 back.

If today’s interest rates are lower, you’ve got an attractive bond to sell. The new owner can earn higher interest than they otherwise could and should be willing to pay a premium for the bond – perhaps something like $1,050.

The result is that the price of bonds, on this secondary market, are inversely related to the interest rate. As rates rise, the price of bonds fall, and vice versa.

And when the U.S. Government needs to sell bonds in the primary market it must offer an interest rate that will attract investors. The news item from the WSJ suggests that interest rates are rising for a couple of reasons. First, with stronger economic results, investors have been returning to the equities market (i.e. stocks), leaving the relative safety and lower yields of the bond market. So demand for U.S. bonds is lower. On the supply side the U.S. Government is accelerating its debt, and needs to sell more and more bonds to cover our deficit. So, decreased demand and increased supply means lower prices, and in this case means the starting interest rate needs to rise.

The other piece not mentioned here, but swirling around nonetheless, is growing concern about U.S. bonds and their credit worthiness. U.S. Treasury bonds have historically had the highest credit rating, reflecting, in essence, risk free investments. There have been mutterings and informal warnings from a couple of credit rating agencies, that they may downgrade U.S. treasury bonds. Were that to happen, then the Fed/Treasury would have to offer higher interest rates on those bonds – to compensate for slightly higher risk.