What to do When You're in a Liquidity Trap?

These are trying times in macroeconomy.  There have been several ways of dealing with severe drops in output.  The first is to lower interest rates, which creates the potential for a liquidity trap after they're lowered to zero.  At that point, we enter the liquidity trap and our knowledge of monetary economics becomes wholly incomplete.  There have been several ways that have been proposed to deal with this problem, and all of them deserve review.

A liquidity trap is defined specifically as the point when bonds and cash become perfect substitutes and traditional monetary policy is no longer effective.  The metaphor that economists use for this situation is that central bankers are "pushing on a string."  These are the situations that cause catastrophic recessions.



 The chart above shows the liquidity trap situation in an IS-LM chart.  Important things to note are that at the point of equilibrium, the LM's slope is flat (indicating the issues surrounding the lower boundary) and equilibrium is to the left of 'full employment' level GDP.

The liquidity trap is a phenomenon of monetary policy.  While the liquidity trap is a somewhat rare situation, it has become a major problem in the past few years for several major economies including the United States.  There has been quite a bit written about this phenomenom in the past ten years starting with essays confronting Japan's economic malaise.

Japan was one of the countries that people described as an 'economic miracle' much like Germany in the same era or China and India in the 2000's.  In the early 1990's, they began having a prolonged economic downturn that never returned to robust growth (yet).  The chart above includes Japan's annual growth rate.  It mostly describes growth around 0-1% with several downturns in 1994, 1998, 2002, and a particularly severe one in 2009.

This chart shows the base borrowing rate that the Bank of Japan uses to affect the economy.  It has been very low for a very long time.  During 2002 and 2009, we can observe liquidity trap, or near liquidity trap conditions.  In 2001, the Bank of Japan pursued a novel alternative monetary policy called Quantitative Easing."  The purpose of this program was to quickly inject more money into the economy under the zero limit boundary conditions.  Current Governor of the Bank of Japan, Masaaki Shirakawa writes about the experience in a working paper, "One Year Under Quantitative Easing."  Some issues that he brings up in the paper are that hoisting up asset prices becomes an act of fiscal policy rather than monetary policy, and that this lends itself to the debate on whether fiscal policy is helpful at all in stimulating an economy.

In the 2008 financial crisis and 2009 global recession, many countries were confronted with a similar situation.  Pronounced contractions while central bank interest rates are already low.  Many countries quickly found themselves in liquidity trap situations.  The ways that they addressed these issues varied.  Lars Svennson was deputy governor of the Riksbank in Sweden, and had already written extensively on such a scenario.  He was most famous for being a proponent of inflation targeting, but also for "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap."

Svennson advocated announcing upward sloping short term price levels coupled with small long term inflation targets.  Then announcing that the currency would be devalued and that the exchange rate would be pegged.  The Central Bank would make a commitment to buy and sell as much currency as they need to maintain the peg.  Once that short term price level target is reached, then the peg is abandoned.

When Sweden found itself in a liquidity trap, Svennson did something that most monetary economists said was impossible.  The Sveriges Riksbank became the first central bank to announce negative interest rates.

There have not been any academic papers about the Swedish experience yet, but it can be said that Sweden had the most growth (nearing 8% one quarter) of any European country coming out of the recession in 2010.  At first glance, it is was successful policy.

The chart above shows that the United States has had several episodes of near zero interest rates.  During the "Great Depression" of the 1930's, interest rates were very low.  These were also the times that John Maynard Keynes originally advocated for activist monetary policies, and even fiscal policies when those were ineffective.  He did not use the term liquidity trap, but The General Theory of Employment, Interest, and Money is basically written from that perspective.

In 1961, the Federal Reserve adopted "Operation Twist" during a period of low interest rates (not zero), as an alternative monetary policy to stimulate the economy.  Now, we have been confronted with near zero interest rates since 2009.  The general economy has recovered to modest growth, but unemployment has remained high due to structural changes in our economy.

This high rate of unemployment has led to a general sentiment that even though we are technically not in a recession, it still feels like recession-like conditions.  It harks back to the old expression that a recession is when your neighbor loses his job and a depression is when you lose yours.  Jobs play a critical part in any economy, and the current jobless recovery has left many Americans dissatisfied with economic policymakers' results.  Above shows that drastic uptick in unemployment, accompanied with relative price stability.  It shows that we did have a period of pronounced deflation despite the fact that the Federal Reserve cut rates, and pursued several rounds of Quantitative Easing.  The United States also engaged in fiscal stimulus.

 CONCLUSION

We still do not have a great idea of how to tackle the liquidity trap.  The typical policies of fiscal stimulus, and alternative monetary policies have (for the most part) been lackluster.  The liquidity trap is one of the most difficult and vexing situations in economics and deserves much more study.  Another issue that confronts policy makers is a large part of economics blames monetary policy for the problem in the first place and are wholly dissatisfied with the remedies.  One fact that they point to is the enormous growth in the monetary base and central bank assets.  They point to this as a sign of coming hyperinflation.  This makes it difficult for policy makers to pursuade the public that the inflation that they are pursuing is managable and desirable, rather than a prelude to hyperinflation.  There is also the problem of the lower boundary.  Bennett McCallum predicts that this might not be zero, but it likely still does exist, so there are still issues there even if it is not quite zero.

It is very possible that Europe may be facing this situation very soon, and perhaps other countries such as the United States would follow in that case.  For that reason, this will remain a critical issue to study in 2012.


REFERENCES:

Krugman, Paul.  "IS-LMentary"  The New York Times.  10-9-11.  Web.

Krugman, Paul, Kenneth Rogoff, and Kathryn Dominquez.  "It's Baaack: Japan's Slump and the return of the Liquidity Trap." 
     Washington DC: Brookings Papers on Economic Activity.  Vol. ? No. 2.  1998.  Journal.
McCallum, Bennett.  "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates."  Boston: NBER.  2000. 
     Working Paper.
Shirakawa, Masaaki.  "One Year Under 'Quantitative Easing'."  Tokyo: Bank of Japan.  No. E3.  2002.  Working Paper.
Svennson, Lars E.  "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others."  The Journal of Economic
     Perspectives.  Vol. 17, No. 4.  Journal.
The Federal Reserve System Purposes and Functions.  Washington D.C.: Board of Governors of the Federal Reserve.  2002. 
     Print.


This article is based on a presentation by Joseph Ward, Hares Fakoor, and Olivia Gonzalez for an intermediate macroeconomics course.