How long will the liquidity trap last?

by on January 14, 2009 at 11:28 am in Economics | Permalink

Is that too silly a question?  (And have purveyors of the liquidity trap argument been willing to make predictions?)  After all, the TED spread is now below one and there are other pieces of financial good news.  If the liquidity trap ends (assuming there was one in the first place), monetary policy will work to stimulate aggregate demand.  A big fiscal stimulus won't be necessary.

Will there still be a liquidity trap three months from now?  Six months from now?  With all those smart people in the White House and at Treasury?  What if there is a ten percent chance, each month, that the liquidity trap goes away?

The proposed fiscal stimulus is a big, irreversible investment, which may or may not be needed, and of course it takes some time to get rolling.  The traditional economist's recommendation is to apply a very high hurdle rate to such commitments.  One alternative is to wait and see if the liquidity trap ends in the near future.

I am not an optimist about the real side of the economy, but I would be surprised if we still were in a liquidity trap one year from now.

1 Bunbury January 14, 2009 at 11:40 am

How did the equivalent of the TED spread look in Japan over the last 20 years?

2 Ken Hirsh January 14, 2009 at 12:17 pm

Could you recommend your favorite article/chapter/book that most clearly explains the math behind the liquidity trap argument?

3 Slocum January 14, 2009 at 12:50 pm

Even if we are in a liquidity trap, why couldn’t we inflate rather than stimulate our way out of it? Wasn’t that the point of Krugman’s baby-sitter parable:

After all, the co-op didn’t start hiring baby sitters, it just distributed more tokens. Seems like a good way to keep people from sitting on their money is to convince them that it’ll buy less in the future than it does now.

4 JH January 14, 2009 at 1:04 pm

So theoretically, the TED spread could be lower because banks perceive T-bills to be just as risking as interbank lending. (Right?)

I’m not saying this is happening — there are clearly other indicators we’d see if that was the case. I just thought it was a interesting way to think about this.

5 Economic Geography January 14, 2009 at 1:50 pm

Steve Sailer is dead on. At least with his first paragraph.

All other things being equal, grand spending projects which are visible and accessible to the taxpayers are infinitely more politically sexy than a Board of Governors meeting on C-SPAN (do they even televise them?)

6 steve January 14, 2009 at 3:30 pm

Heil Sailer!

7 Steve Sailer January 14, 2009 at 4:34 pm

Barkley Rosser:

“His supposed “soul-crushing” defeat
was for a House of Representatives seat in Washington, not exactly
the obvious sprinboard for becoming Mayor of Chicago. Sheesh.”

By running for the House, Obama was attempting to follow the career path of his hero, Harold Washington, who went from the state legislature to the House of Representatives to the Mayor’s Office.

For Obama’s obsession with getting elected mayor of Chicago, see Bill Mundell’s biography of him, which mentions how often he told his Harvard Law School classmates that he was going back to Chicago to follow in Harold’s footsteps and get elected mayor, because that job has real power.

As for his defeat in 2000 being soul-crushing, read Obama’s account of how down he was for the following year in “The Audacity of Hope.”

For his mother’s indoctrination of him during her spats with her unsatisfactory second husband in Indonesia in following in his biological father’s footsteps of becoming a political leader of the black race, see Obama’s “Dreams from My Father: A Story of Race and Inheritance.”

8 Scott Sumner January 14, 2009 at 6:02 pm

Like black holes in physics, liquidity traps have a strange beauty. Until recently most economists saw the concept as tangential to mainstream macro, however Friedman and Hicks correctly placed it at the center of (old) Keynesian economics. Tyler Cowen says “If the liquidity trap ends . . . monetary policy will serve to stimulate aggregate demand.” One could easily reverse the causation; perhaps only a monetary policy that stimulates AD can end the liquidity trap. It is quite likely that when the liquidity trap ends (if by liquidity trap you mean zero short term rates) it will be because the Fed has tightened policy to restrain excessive growth in AD. If we wait for the liquidity trap to end before an expansionary monetary policy can get traction, we may be in for a long wait. The Fed needs to spend less time on bank bailouts and more time reversing deflationary expectations (there a lots of proposals out there about how to do this.)

Zero interest rates are often seen as indicators of a highly expansionary monetary policy, but in another sense they are the result of monetary policy that is far too contractionary relative to the needs of the economy–so contractionary that deflationary expectations have set in. Krugman’s right that liquidity traps are better viewed as expectations traps. But even the “trap” metaphor is inappropriate, as (contrary to Krugman) determined central banks can always create inflation expectations, and hence can always depress real rates when nominal rates are stuck at zero. Japan has experienced 14 straight years of mild deflation (in the GDP deflator.) During that period the BOJ tightened policy twice. Krugman argues that the BOJ was unable to convince the markets that they wanted to inflate–but their actions suggest they got exactly the mild deflation they wanted. Let’s hope the Fed doesn’t make the same mistake.

9 DanC January 14, 2009 at 8:09 pm

Liquidity trap means that people are very uncertain about the future or they see few good investment oportunities.

Perhaps many are holding their breath till they see if Obama is a Social Democrat. So far he wants to be the biggest spending President in history and he will be leaving massive tax increases for the future. Not to mention a drop in the value of the dollar, with increasing inflation and taxes in the future.

Plus the threat that if you are lucky enough to turn a profit you become public enemy number one. What they don’t tax while you are alive they will take at your death bed.

We have people in power who are anti-business, pro-regulation, favor increasing taxes and you wonder why we have a liquidity trap i.e. a view that investors have few good options with their money

10 Barkley Rosser January 14, 2009 at 11:20 pm

Steve Sailer,

OK, fair enough. You have provided some evidence for some of your claims.
Even if what you say is true, so what? Nobody who was running for president
was expecting to have to deal with a major financial collapse and recession.
And, when Washington first won in Chicago, many thought he might reform Chicago
politics, even if later it became clear that this was really just a switch from
one group running the machine to another. Even if one wants to say it was due to
his being beaten by Bobby Rush, do you think that Obama is now a phoney when he
presents himself as a post-racial healer?

A joke about Chicago politics, which I think I have put up here before. This dates
from the period after the Kennedy election in 1960, which some attributed to vote
manipulations in Chicago that gave Illinois to JKF.

So, JFK, RFK, and (the first) Mayor Daley are all stranded on a lifeboat. They realize
that there only enough supplies for one person to survive. So, they decide to have an
election to see who it will be. Each gives a speech. JFK says, “Vote for me, I am the
Leader of the Free World.” RFK says “Vote for me. I am the Attorney General, who enforces
the laws in the United States.” Mayor Daley says “Vote for me. I am the mayor of the city
that works.” In the end, Mayor Daley won, 7-2.

As for the liquidity trap, it is not as trappy as it seems, given that we have seen negative
nominal interest rates.

11 Steve Sailer January 16, 2009 at 4:00 pm

Dear Dr. Rosser:

My view on Obama is that the new President has put a lot of effort into writing two books, a 1995 autobiography and a 2006 campaign book. The problem is that the 1995 autobiography, when read carefully, sharply contradicts the entire “post-racial healer” campaign narrative he’s been running on in the 2000s. “Dreams from My Father” turns out to be exactly and obsessively what it subtitle says it is: a 460 page “Story of Race and Inheritance” documenting Obama’s 25-year-struggle to prove himself “black enough” to fulfill the dreams from his father (as transmitted by his mother) of becoming a political leader who would use his power for the black race.

It’s quite possible that Obama changed his ambitions after black voters rejected him in 2000 for not being black enough, but Obama wrote in 2004 that he wouldn’t change his 1995 book other than to shorten it. So, perhaps his current image is just a concoction invented by David Axelrod to appeal to white voters.

Who knows. The real problem is that _nobody asked Obama_ about the contradictions between the two books.

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