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.

Bureau of Printing and Engraving

My first childhood visit to Washington, DC included a visit to the Bureau of Printing and Engraving. There you can watch paper currency running off the printing presses, being inspected, sliced, and bundled. In the gift shop you can buy bags of shredded, rejected currency, or a sign that says, “The Buck Starts Here.”

Well, in addition to the Bureau, your local community banks also create money. They do it through the system of fractional reserve banking. I just recorded a video clip, available through my PlainSenseEconomics channel on YouTube. It’s for my Macro econ students. And you can watch it, too.

Jeff Stahler - Columbus Dispatch

In Macro class today we talked about what is really a dual decision. First, should our national policy encourage spending or saving? Second, should government actions favor consumption or investment?

First, some definitions and a smidgen of theory. There is a simple dichotomy over  how a family or a nation uses their income. They can spend it (i.e. consume) – which means purchasing goods and services that provide benefits right now. Or they can save it – by putting it in the bank or paying off debts, or even purchasing stock with it. Presumably the savings will improve things in the future (more on that later in this post.) Personal savings (excluding business and government action) have declined as a percent of income since 1980 and probably longer. The personal savings rate was 3.6 percent as of September 2011 (source: FRED). That meant we spent or consumed 96.4 percent.

Savings fuel investment. When households save, businesses save, and the government runs a surplus, this provides funds which can then be borrowed for investment purposes. Done correctly those investment activities will reap economic benefits in the future. If the government operates with a deficit, this adversely offsets personal and business savings. Government borrowing removes funds from the investment pool – a term called “crowding out.”

So, should we encourage people to spend or save right now? Saving brings up good images of a frugal nation, putting aside current desires for a better future. On the other hand, saving does nothing to stimulate demand right now as we struggle to return to full employment. For an extreme example consider Japan in the 1990s, which suffered what is sometimes called “the lost decade.” A real estate bubble popped, causing a typical recession, but then even with low interest rates businesses and families saved rather than spent. They entered what Paul Krugman calls a liquidity trap. Robust economic growth didn’t return for 10 years.

Were someone to ask me this first, spend or save, question, I would recommend incentives to spend – in the short and medium run. Restoring economic activity to its full potential is our most important priority right now – more important than the national debt and more important than future investment. A program to encourage more personal savings would be counter productive.  As the economy starts growing on its own steam, we could then switch to more emphasis on savings.

Consume or Invest?

Now to our second, related question. As government considers fiscal policy (government spending and taxation) it would be wise to target those efforts strategically. Some government spending and some tax cuts will encourage consumption. This can be an appropriate goal during recessionary times, because the added consumption will add directly to GDP. In econ-jargon we call this shifting aggregate demand higher (to the right). If we were considering tax cuts, then targeting low and middle income families will yield the most effective bang for the buck. Lower income families spend more of new income on consumption. Higher income families, having met many of their day-to-day requirements put proportionately more of that new income to saving (including stock purchases.)

Let’s consider what to do once the economy is starting to grow on its own. Do we continue to encourage consumption, or should we shift to investment? I prefer the latter. Investment means putting off the benefits or happiness of current consumption, and directing resources to a better future. Using our tax cut scenario from above, we could argue that cuts should go to higher income families, since they are more likely to save, which in turn should encourage investment. Unfortunately for the advocates of this position there is theory but not much in the way of verifiable results to support this approach.

So, if the economy is growing or starting to regain its momentum, our other choice is to use government spending on thoughtful investments. Pushing aside some of the political wordsmithing, President Obama’s preference for spending on infrastructure fits with this goal. It asks a lot of Congress and the White House to choose investment projects wisely – the lobbying wolves are seldom at bay. There’s an old saw in the grant funding world, that if money is going to support more pigs, successful applicants learn to become pigs. This makes it difficult to thoughtfully target that spending.

My take on this is to be skeptical of general tax cuts – particularly those that funnel most of the money towards higher income families. Tax cuts will fuel consumption at all levels of income, though more consumption among lower income families. And there is scant evidence that money kept by higher income families truly generate savings that lead to thoughtful investment in our future.

China’s economy grew at a higher-than-expected rate of 9.8 percent in the fourth quarter and inflation eased only moderately last month, China’s National Bureau of Statistics said Thursday.

The agency said the economy grew at a rate of 10.3 percent for the full year, while the rate of inflation was 3.3 percent. Inflation fell in December to 4.8 percent, from 5.1 percent in November. G.D.P. growth rose from 9.6 percent in the third quarter and topped the 9.2 percent forecast by market analysts surveyed by Reuters.

The report did little to quell concern that China’s economy was growing at an unsustainable pace.

As my colleague Erik Hurst and his co-authors have shown, states that had the largest rise in construction as a share of GDP in 2000-2006 tended to have had the greatest contraction in that industry in 2006-2009. These states also tended to have the largest rise in unemployment rates between 2006 and 2009.

[Later he points out...]

Hurst estimates that this “structural” unemployment may account for up to three percentage points of total unemployment. In other words, were it not for construction, the US unemployment rate would be 6.5% – a far healthier situation than today.

Structural unemployment speaks to changes in how people are employed – what industries are hiring, what skills are needed, and where the jobs are geographically.

Our Big Mac index, based on the theory of purchasing-power parity, in which exchange rates should equalise the price of a basket of goods across countries, suggests that the yuan is 49% below its fair-value benchmark with the dollar.

Here’s the background. First the theory. In a world of freely floating currency exchange rates, those rates will adjust over time so that a commodity costs the same anywhere in the world. This is called purchasing power parity. An example:  Imagine that Brazil finds some way to sell sugar on the global market at a much lower price than everyone else. Right away sugar buyers can buy more sugar with their own currency from Brazil than anywhere else in the world. This will substantially increase Brazil’s exports.

Now, we also know that if a country’s exports increase significantly their currency will increase in value on the international currency market. That is because all these purchases of Brazilian sugar will increase demand for the Brazilian real. As the value of the real rises Brazilian sugar becomes more expensive to foreign buyers – their own, local currency can’t buy as many real as before. At the same time other sugar exporters may see a slight decrease in the value of their currencies, as sugar buyers switch to Brazil. Over time international currency exchange rates will adjust so that a sugar buyer will be able to buy the same amount of sugar anywhere in the world.  That’s the theory of purchasing power parity. We know that currency rates don’t float perfectly, and in some cases countries seek to influence the value of their currencies. Enter the Big Mac Index.

A number of years ago staffers from The Economist decided to test purchasing power parity (PPP). Rather than using a boring commodity like sugar, they looked at Big Macs, from McDonalds. Big Macs are as close to a commodity at the definition allows – virtually identical everywhere. They recorded the price of Big Macs in scores of countries, converted those prices to dollars and tested the PPP theory. The results showed a wide range of prices for Big Macs.

Now, these results could disprove the PPP theory. Instead, The Economist staffers maintained that PPP was true, and that various countries’ currencies were either over-valued or under-valued. Let’s use China as an example. Earlier this year a Big Mac cost $3.58 in the United States, but only $1.83 in China (after converting yuan to dollars). If PPP is true, then China’s currency is under-valued by almost 50 percent. And, in fact, there is considerable angst in the international community about China’s efforts to artificially lower the value of its own currency in order to protect its huge export market and supporting industries.

Economists love to forecast, and yet have a very mixed record of success with their forecasting. The Big Mac Index can be used as a rough forecasting tool. In the March, 2010 article the Euro was 29% over-valued. Over the last six months the Euro has declined in value against the U.S. – just what the Big Mac Index would predict.

Who says economists don’t have fun?

The United States has discovered nearly $1 trillion in untapped mineral deposits in Afghanistan, far beyond any previously known reserves and enough to fundamentally alter the Afghan economy and perhaps the Afghan war itself, according to senior American government officials.

The previously unknown deposits — including huge veins of iron, copper, cobalt, gold and critical industrial metals like lithium — are so big and include so many minerals that are essential to modern industry that Afghanistan could eventually be transformed into one of the most important mining centers in the world, the United States officials believe. (Source: New York Times, June 13, 2010)

This is a good opportunity to review the core economic concepts of scarce resources and production possibilities. Classical economics starts with the idea that resources which can make us happy, or make our nations thrive are scarce – there are not enough resources to satisfy all of our needs. Going from here, classical economics studies how people and nations make decisions on the allocation/use of those scarce resources.

Afghanistan is a desperately poor nation – with a GDP of $800 per capita; compared to $46,400 for the U.S. (Source: CIA World Factbook). Much of this is due to decades of war and conflict within its borders. It must allocate a small number of scarce resources to a variety of outputs. Just two of these many outputs might be food production (necessary for health and a standard of living) and textiles (necessary as an export good).

Before and After the Discovery of Mineral Deposits

We use a production possibility curve to illustrate the decisions on how to allocate scarce resources between two outputs. Consider this sample graph.

We choose two outputs – food and textiles – and place one on each axis. The points where the curve touches an axis represent the theoretical output if all scarce resources were devoted to that single output. More realistically, the curve represents various combinations of outputs, based on allocating those scarce resources between the two outputs. If the country operates on its production possibility curve, it is using all of its resources efficiently. If it operates below the curve, some scarce resources are not being used.

Now, all of a sudden, Afghanistan discovers that it has these vast reserves of precious minerals. The possibilities in their economy will improve. The production possibility curve will shift out and to the right. The challenge for this country hobbled by poor transportation networks, corruption in government, and active hostilities within its borders is to reach this new production possibility.

In this piece, by Univ. of Oregon professor Mark Thoma, you will find a review of the three kinds of unemployment and a discussion of what “normal” or “natural” employment is.

Will There be a “New Normal” for Unemployment?

Thoma also writes in his very popular, Economist’s View blog, and has a number of his upper division lectures available on YouTube.

Here is the rap version, for your entertainment. The player below gives a teaser, with a link to the full version, which is free to listen to.

Demand, Supply – Rhythm, Rhyme, Results

This article in the March 2, 2009 edition of The New Yorker, by James Surowiecki, does a nice job of explaining both of these phenomena.

A quick excerpt from the the lead…

It’s harder and harder to find and keep a job, but if you’ve got one you may well be making more than you did twelve months ago.

We can think about labor as a market, where workers “supply” their time and expertise, and employers “buy” that time and expertise. If workers become more productive they are more attractive to employers and the demand for labor shifts to the right (increases). If nothing else changes (fat chance of that!) then an increase or shift in demand should result in higher wages. The article explains how, due to a number of factors, worker productivity has been rising at a nice clip – resulting in higher wages.

Now, if we look around us at rising unemployment and laid off workers seeking any kind of employment at almost any wage, it would be reasonable to expect that wages would start falling. After all there is an abundance of available, potential workers, so why wouldn’t wages decrease? They do, over time, but not right away. This is the “sticky wages” phenomenon. Some times there are structural reasons that wages stay the same. This might include a negotiated union contract, or a heavily bureaucratized wage and salary structure (think schools or public government employees, or sometimes hospitals). To add to that is at least some empathy on the part of the employer – trying to do the right thing for their work force in hard times. Surowiecki also notes employer concerns about adverse selection, where the employer fears losing their most productive employees as a result of a wage cut.

Eventually wages do start falling in hard times, along with prices. This change isn’t immediate, but with a prolonged recession it is inevitable.