The liquidity trap!

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3 mins. to read

By Filipe R. Costa. 

After printing trillions of dollars to spur growth, the Federal Reserve isn’t exactly doing very well in its goals of stimulating the economy and increasing employment. At best economic output is wobbly and long-term growth trends continue to slow. Faced with such a lackluster performance it makes perfect sense that the central planners press ahead with more of the same failing interventionist policies! (Ahem….)

Assuming she makes it through her confirmation hearings, Janet Yellen will inherit the hot seat at America’s central bank in what is probably its darkest hour. The same Keynesian principles which have inspired the highly accommodative monetary policies of recent years now point to a new danger. With short term interest rates near zero, the velocity of money at record lows and prices relatively unchanged after trillions of dollars of base money expansion, there is no doubt we are living in a Keynesian liquidity trap.

No matter what positive spin is put on manipulated economic statistics it is obvious that people prefer to hold cash in these uncertain times. They might not realize it, but a collective consciousness seems to be at play. Intuitively we all know that nothing has been fixed and the current system has to fail. The hording instinct has kicked in and people are preparing themselves for worse times ahead. Thus the key driver for economic growth (money!!!) is removed.

With rates at record lows, there is little the Fed can now do to encourage expansion. In other words, there is no real benefit from current monetary policy, as the following IS-LM framework suggests;

Any attempt at following even looser monetary policy would shift the LM curve to the right to LM’. The equilibrium would be exactly the same as before. This has serious implications for the Fed’s position. In simple terms it means that the Federal Reserve has successfully managed to plonk itself on exactly the same failed path as the Bank of Japan did 20 years ago. Ever heard of the “Lost Decade”?

Well, we are seeing its twin being born today.

Unable to induce genuine growth, the central planners can only resort to distorting financial asset prices. Their aim is to push investors out of the bond market and into the stock market. Alan Greenspan and Ben Bernanke used up all the policy ammunition unwisely. Now there is none left. Using Keynesian theories as the basis for future decision making, Dr Yellen is going to find she’s out of luck justifying further QE on that front.

So what about fiscal policy to boost output?

Represented by the IS curve above, unfortunately the story here is just as bad. If the government attempts to use fiscal policy to boost the economy the IS curve would shift to IS’. Theoretically output would be pushed higher, without pushing rates higher.

The problem in the real world is that governments have spent and borrowed far too much over the last decade or so. They now have to deleverage as much as the rest of the economy does. Their coffers are empty, which explains why responsibility has been handed over to central banks for job creation and growth.

In the final desperate attempt to create this “growth” it is highly likely the central banks of Japan, Europe and America will use more and more of the unconventional monetary policies. What else can they do?

This should continue to push financial asset prices higher until eventually they burst. There is a certain tragic inevitability about all of this. When it happens, expect to be able to pick up your favourite stocks for roughly half what you’d pay today!

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