Voices of Madmen in Authority Distilling Their Frenzy

“When policy-makers have already witnessed a significant move in asset values, and are confident in what that move means for the outlook, it should be prepared to adjust policy accordingly. The central bank must be responding to its assessment of what an already observed movement in asset prices will mean for output and inflation.”

- Timothy Geithner, at the NY Association for Business and Economics.

“Monetary policy itself cannot sensibly be directed at reducing imbalances.”

- Timothy Geithner, at the Global Financial Imbalances Conference in London.

“To do otherwise would run the risk that monetary policy would be too accommodative, pulling resources from the future in a way that would alter the trajectory for the growth of the capital stock, perhaps amplifying the imbalances, and compromising the price stability.”

- Timothy Geithner, at the Japan Society Corporate Luncheon in New York City.

"...in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

- John Maynard Keynes, General Theory

Liquidity Trap --> Recession

What is a Liquidity Trap?

A liquidity trap happens when interest rates come closer and closer to zero, and thereby changes in the money supply are very ineffective at stabilizing the economy.

If at first blush that does not make sense, another way to put it is like this.





"LM" is the money supply and liquidity preference combined in the IS-LM model. Visually, the central bank is trying to get the economy to "YF", which means a higher overall economic output and full employment. But when a central bank increases LM with interest rates so low like this, it does not change Y. So the monetary "transmission mechanisms" are essentially useless. On September 17 the interest rate for 3-month treasury bills (the most popular) fell to 0.06%, the lowest on record, and today are standing at 0.08%.


Japan: a case study


U.S. interest rates were well below 1% throughout the Great Depression, and the same was true for Japan in the 1990s, where they stood at one-tenth of 1%. Neo-Keynesian Gregory Mankiw, economist and author of the popular Macroeconomics textbook, says the crisis in both cases were traced to bad stock performances. Japanese land prices also peaked in the 1980s before crashing in the 1990s. It was a speculative development bubble, similar to the current one in the U.S. When the value of these holdings collapsed, the Japanese "saw their wealth plummet" and this "depressed consumer spending". [found on p.324]


Next, the banks

"ran into trouble and exacerbated the slump in economic activity. Japanese banks in the 1980s had made many loans that were backed by stock or land. When the value of this collateral fell, borrowers started defaulting on their loans".

This should sound very, very familiar to the U.S. sub prime mortgage default situation.

"... these defaults on the old loans reduced the banks' ability to make new loans. The resulting 'credit crunch' made it harder for firms to finance investment projects and, thus, depressed investment spending."

What made the downturn worse were the low interest rates which made monetary 'stabilization policy' ineffective. That is to say, the liquidity trap. Both the Great Depression and 1990s Japan saw low economic activity coincide with low interest rates.

"... this fact suggests that the cause of the slump was primarily a contractionary shift in the IS curve, because of shift reduces both income and the interest rate. The obvious suspects to explain the IS shift are the crashes in stock and land prices and the problems in the banking system."

Mankiw says the policy debates during the Great Depression and Japan during the 1990s were essentially the same: Keynesian, but he does not use this word.

"Some economists recommended that the Japanese government pass large tax cuts to encourage more consumer spending."

It was their version of today's Paulson Plan. These sorts of plans aim to shift out the IS curve instead of the LM curve. But during both the Depression and in Japan policymakers wanted to avoid budget deficits from cutting taxes and/or increasing spending.

"...Other economists recommended that the Bank of Japan expand the money supply more rapidly. Even if nominal interest rates could not go much lower, then perhaps more rapid money growth could raise expected inflation, lower real interest rates, and stimulate investment spending."

Eventually the Japanese plan was a combination of shifting IS and LM together. If we measure recovery by unemployment, for example, Japan still has not recovered. Unemployment was 2.1% in 1991, 5.4% in 2002, and 4.5% by 2005. Real GDP grew by 4.3% during the Japanese "miracle" boom of 1980s, but during the 1990s it grew by 1.3%. This is very low by developed-country standards, and generally considered undesirable, even unsustainable.


Today's Economic Portrait


"The liquidity trap" has not entered mainstream public consciousness yet. But as Paul Krugman wrote last monday, the fact that we are dabbling in liquidity trap territory is becoming obvious.

"You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills — the two sides of the Fed’s balance sheet — become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent."

Krugman has been saying since March of 2008 that we're "pretty close" to a liquidity trap. This September we are sliding against a razor thin margin, and the possibility that we are already in a liquidity trap will only be known months later given time lags in economic data.

The technical definition of a recession is 'two consecutive quarters of falling GDP'. But another, probably more apt, way to define recession is how many times the word comes up in the mainstream press. The more the word "recession" is used, the more consumer confidence drops, and the likelihood that we are actually in a recession becomes realistic. But the press have been using the word "recession" throughout the entire year it seems (just do a Google "trends" search), so I am beginning to think this is not a good barometer.

My new thought is that once people start using the phrase "liquidity trap", it will imply that our understanding about the severity of the crisis has developed to such an extent that you can be sure we are in a real recession.

Inflation-Targeting is a Bad, Discretionary Policy

Conservatively dressed central bankers may not look like fashion victims, yet they are as prone to the latest craze as anybody else. Remember when monetarism was all the rage? The latest fashion is for inflation targets.

The Fed announces a target for inflation, usually between 1.5 and 2%, and then it adjusts the money supply as it sees fit. It insulates the economy from changes in the velocity of money. It also has the "political advantage" that it is easy to explain to the public.

The politicians and the paternalists counter that an inflation target would give the Fed too little flexibility to stabilize growth and/or employment in the event of an external shock. Today the Fed continues without the strict rules of an explicit target. Greenspan, as well as other former FOMC members such as Alan Blinder, typically agreed with its benefits, but were reluctant to accept the loss of freedom involved; current Chairman Bernanke, however, is a well-known advocate of inflation-targeting.

Should we interpret inflation targeting as a type of precommittment to a policy rule--to simply keep inflation down? Not completely. In all the countries that have adopted inflation-targeting, central banks are left with a fair amount of discretion. Inflation targets are usually set as a range--an inflation rate of 1 to 3 percent, for instance--rather than a particular number. Thus, the central bank can choose where in the range it wants to be: it can stimulate the economy and be near the top of the range, or dampen the economy and be near the bottom. Sometimes central banks allow adjustments to their targets as well--a time inconsistency.

So what is the purpose of inflation targeting if they're all so flexible? When a central bank is simply told by politicians who don't understand it to "Do the right thing," it is difficult to hold anyone accountable. Politicians give the banks some discretionary room, but the banks try to achieve the goals of the politicians, or perhaps worse, a social-welfare ideal.

What about the Federal Reserve? Since Bernanke took office, we might expect a move toward inflation-targeting as the explicit framework for monetary policy, since he is an advocate of inflation targeting. As a commentator from Mises.org said, "We should understand this to mean that Bernanke is a deflation-scared inflationist."

The Time-Inconsistent Government Policymaker

Policy is conducted by rule if policymakers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement. Policy is conducted by discretion if policymakers are free to size up events as they occur and choose whatever policy they consider appropriate at the time.

When government policies are time-inconsistent, this means that it's a scenario in which the government has an incentive to renege on a previously announced policy once others have acted on that announcement. This destroys all credibility in the government-run economy, the state-owned economy. This happens today quite a bit. For example, to encourage investment, it would be announced that no taxes will be collected from capital income. But once factories are built, the government reneges in order to raise more tax revenue for welfare policies or war budgets. Or for example, to reduce inflation, the central bank even might announce that it will tighten monetary policy by reducing the money supply. But if faced with high unemployment, the central bank may be tempted to cut interest rates.

I read of an example a while back in which aid was given to an underdeveloped country that announced a fiscal reform plan. Once the aid was given, the reforms did not occur. Or maybe it was because the reforms did not occur that the aid was still given--because the donor countries didn't want to see the citizens starve.

One of the first problems that Alexander Hamilton dealt with then he was appointed first U.S. Secretary of the Treasury in 1789 was the time-inconsistencies of the debt plan. When our revolutionary government incurred the debts, it promised to honor them when the war was over. But after the war, many Americans advocated defaulting on the debt because repaying the creditors would require taxation, which is always costly and unpopular.

Hamilton opposed the time-inconsistent policy of repudiating the debt. He knew that the nation would likely need to borrow again sometime in the future. So in his First Report on the Public Credit, presented to Congress in 1790, he wrote

The ready answer to this question is, by good faith; by a punctual performance of contracts. States, like individuals, who observe their engagements are respected and trusted, while the reserve is the fate of those who pursue an opposite conduct.

So, honoring the debts, Hamilton opposed time-inconsistent discretionary policies. Today, unlike in Hamilton's time, when Congress debates spending priorities, no one seriously proposes defaulting on the public debt as a way to reduce taxes. In the case of public debt, everyone now agrees--or at least ought to--that the government should be committed to a fixed policy rule. Discretionary policies should not be within the power of policymakers. Actually, they shouldn't have the power to announce policies that would even tempt them to renege later. By this I mean things like involuntary taxation. It's too much of a cookie-jar for the inconsistent policymaker. Taxation should not be within their power, unless, it seems in the case of Hamilton, to repay the public debt. Which, by the way, we still owe.