Out of the Liquidity Trap?

Professor Krugman has produced an interesting graph that — according to his calculation — suggests that while we’re not quite out of the liquidity trap, we are getting closer:

It’s a useful contribution, that shows just what the Federal Reserve does in terms of trying to match interest rates to the broader inflationary outlook. The liquidity trap at the zero bound is clearly visible — the Fed cannot cut rates below the zero bound, which renders traditionally monetary policy essentially useless. (Austrians will of course interject here that traditional monetary policy is worse than useless, but that is another story for another day).

If the liquidity trap is ended, we should eventually see higher demand (Krugman’s point is broadly that stimulus would fight off the problem of the liquidity trap and solve the problem sooner). The Krugmanites think that demand is the only problem, and higher demand (even if that is down the line and later than Krugman would like it) will cure our economic woes.

I completely disagree and believe that depressed demand is not the main problem, but merely a symptom. I believe that the credit contraction that occurred in 2008 was a direct product of various non-monetary challenges that America faces, almost none of which have been solved, or will be solved by an end to the liquidity trap:

The three main problems are a lack of confidence stemming from high systemic residual debt, deindustrialisation in the name of globalisation (& its corollary, financialisation and that sprawling web of debt and counter-party risk), and fragility and side-effects (e.g. lost internal productivity due to role as world policeman) coming from America’s petroleum addiction.

In the months and years to come we will see who is right.

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25 thoughts on “Out of the Liquidity Trap?

  1. If the US government was to acquire more debt for Keynesian stimuli, they should have spent the funding on restoring infrastructure and manufacturing, not on banker bailouts and wars. Three month ago I visited America and I was totally frustrated by their slow internet speed. Why not spend a few billion $ on optical fiber LAN cable infrastructure? Japan is making robots with all gadgetries. Research industrial robotics, then why offload industrial capacities to China when technical gadgets can be made in America with no labor costs via robots?

    I partially agree with Krugman. Treasury yields are at all-time lows and the US government may take advantage of it to “grow out of debt.” But for some reason they seem to be getting into more debt by saber-rattling with Iran…….

    • If the US government was to acquire more debt for Keynesian stimuli, they should have spent the funding on restoring infrastructure and manufacturing, not on banker bailouts and wars.

      I agree with this in principle, but I think as time rolls on government is proving itself useless at investing in the right stuff, and only capable of spending money on wars and cronyism. Central planning fails again.

      Noah Smith wrote a very interesting article on this. He is MUCH more optimistic that government will do the right thing than I am. I am very, very pessimistic, and believe more spending will just hurt more when rates eventually rise.

      http://noahpinionblog.blogspot.com/2012/01/is-debt-burden-on-future-generations.html

      • Noah’s opinion is similar to mine – when asking whether running up our debt will impose a burden on future generations, the key question is what the government will do with the money it borrows. However I totally agree with you that our governments have been proved itself useless at investing in the right stuff. I realized that the South Korean government is totally useless at investment when it decided to build 4 canals in a country a bit larger than Scotland. It was only several months ago during the sovereign debt crises that I found out other governments around the globe were not much better.

    • I agree with you. I saw a wasted opportunity. I was expecting Obama to announce and infrastructure modernisation programme. I visited the USA 10 years ago, and found many of its key bridges, rusting and looking decrepit. Although structually sound, it gave me a different impression of the Big Apple. More like the blemished rotting apple.

      • It is amazing how America has accrued so much debt while neglecting the two key aspects of government: infrastructure creation (of the useful kind — no bridges to nowhere) and the protection and defence of liberty.

  2. There is trillions of “liquidity.” The problem is the “real” interest rate is near negative. Inflation rate minus interest rate. Loaning money at 3.99% with a inflation rate of “3.4%” does not stimulate risk taking or savings.

    Krugman is a idiot, and will be wrong for the 103 time. Beating up on Krugman is useless.

    • Attacking Krugman right now is very important, because he just made a testable prediction that I believe will soon be empirically disproven. More demand will not meet the underlying challenges.

      • What that line is showing is inflation. Will we get inflation for all the “liquidity” injected into the market, hell yea.

        Krugman will never understand the problem is not inflation, or deflation, it is liquidation of bad assets and REAL saving and investing. To get real saving the Fed should have pegged the FF rate at the inflation rate plus 3% to attract savers. This would reduce consumption of consumers and free up resources for capital producers. Flooding the market with cheap dollars creates disinformation in the markets and misallocation of resources. This is beyond the understanding of the simpleton Krugman.

        I predict this shit explodes in 2012. Its a miracle it has not yet. The only reason it has not yet is the holder of Greek and Italian bonds are not asking for payment from the Greeks or their insurance carriers.

        Don’t waste your time with Krugman, he is a fool.

        • Krugman will never understand the problem is not inflation, or deflation, it is liquidation of bad assets and REAL saving and investing.

          Flooding the market with cheap dollars creates disinformation in the markets and misallocation of resources. This is beyond the understanding of the simpleton Krugman.

          I agree. I’m not entirely sure that pegging the Federal funds rate to inflation plus three percent would have made any difference if their goal is to not allow bad companies and banks to fail. The entire ZIRP scheme is all about reinflating the bubble, and what you’re suggesting would instigate the liquidation we so badly need, but which the Keynesians refuse.

          I predict this shit explodes in 2012. Its a miracle it has not yet.

          I don’t know about this. The Keynesian can-kickers will kick cans ’til the cows come home. As Ron Paul has said in the past, Austrian business cycle theory only tells us that there is a bubble; it doesn’t tell us when the bubble might burst. We know there’s a bond and debt bubble. We don’t know when or how it will blow up.

          I also think they would introduce a new monetary regime before they allow liquidation. They really, really hate Hayek.

        • I agree with you. Sometimes you can get very tired arguing with idiots. He is just a mouthpiece.

          I also agree that interest rates should always reflect inflation plus a risk premium plus a normal profit margin in an efficient financial intermediary. It encourages savings, and reduces capital costs for new technological expansion.

          The characteristic of all credit bubbles is the building of property and skyscrapers. There is nothing to invest in other than speculation.

          Whenever I hear about the biggest building being built it is time to bunker down.

          Only idiots will start to consume. If they think they will have a job in 5 years to pay back or draw on their savings to buy that 3rd car or TV, then they obviously work for the Government or are the CEO of the company.

  3. Typical Shovel Ready project in the “thumb” area of Michigan. Stimuli used to build a big wind farm. Now up an spinning – but not connected to the grid. Electric company had sold the rights to transmission lines. New owner won’t connect the wind farm unless someone (?) pays for the new transmission lines. Local government slaps massive property tax on windfarm. Power companies won’t buy even if there is a line – too expensive due to taxes built into the price. Government in Action.

  4. I give Krugman a pass on this one because he is saying Greg Mankiw is wrong. This week I support anyone who says Mankiw is wrong after his ridiculous post about traffic in Seattle: http://gregmankiw.blogspot.com/2012/01/how-to-reduce-traffic-congestion.html

    Being on the East Coast and talking about how the 520 Toll reduces traffic congestion is such arrogance. All that has happened is the congestion is worse on the 90 bridge and the roads between the two.

    This is just an example of very real “crowding out” and Mankiw missed it.

    Point, Krugman.

  5. The Fed is not out of Monetary ammunition. They can cut by 0.25%

    Can you imagine the advertising! 0% Financing for 10 years.

    You watch the brawls at the malls.

  6. I understand that ultimately he disavows even his own more pessimistic graph due to a “lot of information coming” which makes him believe that the US should print/spend with abandon and with a total disregard for the actual ensuing inflation (or Taylor’s rule).

    • I am sceptical the Taylor rule really achieved much. Throughout the “Great Moderation” Western economies were flooded with cheap and readily available Chinese goods, cheaper and more readily available food, etc. Housing and services had to inflate just for “price stability”, and that was probably the beginnings of the bubble. That’s my intuition, anyway.

      • I never thought of it that way. Good thinking 99.

        If we had deflation, due to imported consumer goods, a good agricultural year, the Central bank would have to maintain inflation at 3%.

        You guessed it, they pumped up the cost of housing, electricty and health services. When a starter home in the 70′s cost 3 times yearly wages (One breadwinner) it now costs 4-5 times with two bread winers!

        BTW, whilst on the topic of Keynesian pump priming, the Australian Governments claims credit for increasing employment (48% of these jobs were in the public/civil service) check out this list of all the Australian Government Departments (Federal)

        http://www.directory.gov.au/

        As I will be running as a Senator, I am writing to each Department Head to justify why they must exist, how many staff they employ, average and median income and total yearly budget and growth over the past 5 years.

        These departments are an expensive work for the dole programme. People need to pressure Government to reduce the civil service. The Wages, Pensions and Benefits

        • The more I think about this the more problems this actually creates. If more and better productivity naturally tends toward deflation, price stability necessarily stipulates big inflation in more limited products (i.e. housing, services). This means that the notion of CPI price stability is detrimental because in a world that is increasing productivity it very, very likely will create unsustainable price increases in certain sectors.

          We have stumbled onto some very interesting stuff here.

        • I agree, something all contributors should look into.

          Deflation is the outcome of rising productivity. I am reading Das Capital at the moment and Marx bangs on commodities having a labour component. Reduce the labour component (Productivity) and the value should decrease.

          This is a good thing as we have more goods for less human effort. Life should be this goal. This is a primitive societies fantasy.

        • I find it funny that even the most basic tenets of economic theory are open for discussion. Only lends more credence to those that say the “economy” works/worked in spite of all the economic theory (i.e. for reasons like cheap oil and… some luck etc.) Not talking only about CPI here, but basically the entire political/economic scene is filled by people espousing totally different and logically incompatible views on how the economy can be “fixed” etc.

  7. I wish I could claim I said this but I think it was a commenter on Zero Hedge who put it thus: Volcker and Greenspan had three buttons on their desks, interest rates up, interest rates down and print. Now Bernanke has only one button that works, the print one.

    It is amazing how many different names they have cooked up for it, but everything they do seems to boil down to printing. I shudder to think what the effects will be on pensioners, and the vast majority of Americans who are so blissfully unaware of the thin ice they are on. If the real costs of petroleum only quadruple, that will be a relatively good outcome. Even I don’t want to think of what the bad outcomes might be.

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