The attention-grabbing event in the economy over the past week was Thursday’s 512.76-point plunge in the Dow Jones Industrial Average. The more significant event may have been Bank of New York Mellon’s move to charge big corporate customers a fee for putting money on deposit instead of paying them interest. It is a symptom of an economic malady that John Maynard Keynes called “the liquidity trap,” and one reason why the U.S. economy is having such trouble climbing out of the hole it’s in.
A liquidity trap is a rare condition which appeared during the Great Depression and was thought to have been wiped out until it reappeared in Japan in the 1990s. The U.S. has contracted a severe case. The condition is characterized by an economy in which interest rates are so low that consumers, business and investors don’t care if money is in cash or in
interest-paying investments. BNY Mellon was reacting to a run to the bank by companies fleeing even U.S. Treasury bills for the safety of the bank.
Keynes called it a “trap” for two reasons. One, as long as consumers and businesses hold cash instead of spending or investing it because they expect the economy to be weak, the economy will be weak. The companies of the S&P 500 collectively have $963 billion in cash, a sum equal to twice the annual output of the state of Ohio. Two, it makes the Federal Reserve’s usual monetary policy impotent. Cutting interest rates below zero is (almost) impossible. Printing money to buy bonds creates sterile bank reserves but not much additional lending or spending. The liquidity-trap notion was the subject of much debate between Keynes and his contemporaries in the mid-20th century and was revived at a 1998 Brookings Institution seminar by Princeton University economist Paul Krugman. “Nobody thought that a liquidity trap could happen in Japan,” he wrote. “Now that it has, we should wonder whether it could happen elsewhere.” (His guess, then, was Europe.)
Not everyone is convinced. “The relatively dubious reputation of the liquidity trap is well deserved,” said Bentley College economist Scott Sumner. If we are in a liquidity trap, how do we get out of it? Economists have three remedies, all with such significant side effects that there’s a reluctance to attempt them.
One, the classic Keynesian prescription is for the government to borrow (after all, rates are low and savings idle) and spend to create demand and jobs. In today’s context, that would mean Washington borrowing and spending now while enacting credible deficit-reduction policies (not promises, but changes in law) that bite later. Perhaps the government could do in the next couple of years all the infrastructure projects it is likely to undertake over the next decade, leveraging taxpayer money with private partnerships and levying tolls or fees to
help pay off the debt later.
But many Americans and most congressional Republicans are convinced that President Barack Obama’s first try at fiscal stimulus was a flop, and has created an unbearable debt burden. A second round appears politically impossible—for now. Two, Lars Svensson, now deputy governor of the Swedish central bank, sees one “foolproof way of escaping from a liquidity trap”—devalue the currency. “This,” he wrote in 2001 while in academia, “will jump-start the economy and escape deflation.”
Although the U.S. government and the Fed have, though not explicitly, been counting on a decline in the dollar to help boost exports, an explicit dollar-weakening campaign is unlikely—and unwise given the dollar’s role as anchor of the global financial system. Three, the interest rate that matters in the economy is the sticker-price rate adjusted for inflation. So some economists argue that the way out of the trap is for the Fed to convince everyone it’s going to create more inflation. If inflation goes up and interest rates don’t, then the inflation-adjusted interest rate falls—and goes negative—and that will give people cause to borrow and spend.
This appeals to Kenneth Rogoff, the Harvard economist who argues that adding to the already-heavy government debt burden (see option one) is a mistake: “The only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4% to 6% for several years.” Incomes rise with inflation, debts wouldn’t, and they’d be easier to pay off. Fed Chairman Ben Bernanke, no stranger to unconventional prescriptions, winces at this one. He’s not convinced the Fed could create just a little more inflation, and fears the sustained damage if the central bank is seen as abandoning its commitment to price stability.
Failure to arrive at the correct diagnosis, in economics as in medicine, prolongs the illness; so does refusing the remedies. There’s a reason the Great Depression lasted for more than 10 years.
http://online.wsj.com/article/capital.html
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