Stephen Williamson on the liquidity trap

by on August 24, 2011 at 2:49 am in Economics | Permalink

The scarcity we are observing is not a traditional currency scarcity. As such, we can’t correct the scarcity by using conventional central banking tools – open market operations in short-term government debt and discount window lending. Neither can we correct it through “quantitative easing.” We cannot ease anything through swaps of reserves for long-maturity debt, as that cannot make reserves relatively less scarce under the current circumstances. But the inability of monetary policy to correct the liquidity scarcity problem has nothing to do with the zero lower bound on short-term nominal interest rates, as the key problem is a contemporary liquidity trap, not Grandma’s liquidity trap.

How can government action mitigate the liquidity scarcity? If monetary policy cannot do it, that leaves fiscal policy. But there is a tendency, particularly in the blogosphere, to frame the problem in Old Keynesian terms. In this view, we are facing Grandma’s liquidity trap, the LM curve is flat, monetary policy doesn’t work, so shift the IS curve instead. Further, unemployment is very high and persistent, so it might seem natural to have the government employ people directly by spending more. But the problem here is financial, and it’s not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia.

One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.

Here is more, and you can take this post as a validation of many (not all) of the broader methodological points Williamson likes to make.  “Neoclassical macroeconomics” is not totally out to lunch, and it is ignored at our peril.

dearieme August 24, 2011 at 3:37 am
rluser August 24, 2011 at 4:16 am

Please do not defecate in the pool (such as it is). Such a link is on topic somewhere.

dearieme August 24, 2011 at 1:46 pm

Is your mother proud of your language? If not, perhaps she’ll expel you from your basement room.

anon August 24, 2011 at 4:27 am

Steve Williamson is confused. If safe assets are scarce, that’s an increase in the price of safe assets, i.e. a decrease in risk-free returns, not a “liquidity issue”. The policy implication is that we need to create more safe assets (such as, yes, by having the US goivernment incur more debt) or lower the risk-free real rate, e.g. by charging negative nominal rates or by increasing future inflation. (But in fact, if we’re in an AD shortfall, monetary easing would suffice to improve growth expectations and long-run real rates would increase on their own.)

Nemi August 24, 2011 at 7:20 am

Agree

Jonathan August 24, 2011 at 5:23 am

How about removing the premise that top down tinkering is actually required and might actually be part of the problem frustrating the markets signalling mechanism?

As the piece goes through one by one the failed/failing policies to conclude with concocting another one which in essence will just mask underlying market signals, again, with unintended long term consequences that will then require ever more involved policy responses… repeat, wash, repeat…

Cahal August 24, 2011 at 5:26 am

The fact most neoclassical economists think the IS/LM curve is ‘old Keynesiasm’ – and probably believe it is Keynes’ central contribution to economics – shows how bad the situation in mainstream economics is.

Pragmaticon August 24, 2011 at 10:56 am

What? IS/LM is Old Keynesianism. What else would it be? Unless you’re being pedantic for the sake of being pedantic, 99% of everyone sticks the 50s/60s/70s crowd of ISLM and large scale macroeconometric models into the “old keynesian” basket. Then in the 90s and 2000s the sticky wage/price DSGE models of Woodford and company are known as New Keynesian…

Cahal August 24, 2011 at 1:30 pm

I regard IS/LM as ‘New Keynesianism’ or, more accurately ‘bastard Keynesianism’ along with the rest of the post-war consensus (Phillips Curve, Excess wages causing unemployment, elimination of uncertainty). It is Keynes made safe for the surreal world of neoclassicism. The ‘New Keynesianism’ you reference is incredibly similar, minus perhaps the phillips curve.

The fact that anyone who calls themselves a Keynesian uses IS/LM when it was explicitly rejected not only by Keynes, but by the man who came up with the model, says a lot about economics.

TGGP August 25, 2011 at 1:00 am

I think the term “Neo-Keynesianism” is used to refer to the Samuelson/Hicks fusion of neoclassical (post-marginal revolution, using graphs and math) with Keynesian, as opposed to Post-Keynesianism (which claims to be truer to the economics of Keynes). New Keynesianism is the newer fusion.

E. Barandiaran August 24, 2011 at 5:34 am

Tyler, I’m glad that you have linked to SW’s post. I’m afraid, however, that you will have to translate it (= go beyond SW’s academic presentation) and to comment on it in detail. Otherwise it’s quite hard to relate it to other views on the ongoing debate about monetary and fiscal policies.

In particular, and after you have gone in detail through all the post, you will have to comment on the last two paragraphs (the ones following immediately after the last paragraph of your quote) because they are critical to SW’s position but cryptic:

What’s the difficulty here? Well, the US government apparently has a very difficult time making decisions on fiscal matters, and seems not to like commitment, so what I am proposing is just not feasible politically. You might think it convenient if the Fed could conduct limited types of fiscal policy, but that requires giving the power to tax to unelected officials, and that seems a bad idea.

So where does that leave us? The key financial problem facing us is a scarcity of other liquid assets, not a traditional currency scarcity. The Fed is powerless to solve that problem; the Treasury could in principle solve it but cannot. For now, the Fed can only monitor the economy for signs of a more serious inflation. Some of those signs may already be there, for example in currency growth, though it is hard to tell what is driving that.

End of quote.

In your translation and comment, please explain (1) differences in the definitions of the concepts used by SW and others, in particular the differences between “safe” assets and “liquid” assets, differences between “liquid” assets and means of payments, differences between “liquid” assets and liquidity management;

(2) differences in the diagnosis of some sort of liquidity trap based on those definitions, making clear the meaning and implications of SW’s views on rates of return and liquidity premia;

(3) for that diagnosis how you read the data that SW refers to, in particular about large differences in the growth of currency, bank reserves, demand deposit accounts (in M1), savings and time deposits (in M2), the Treasury’s outstanding debt and the Treasury’s debt hold by the Fed;

(4) what instruments the Fed really has in SW’s view, and given that diagnosis why the instruments appear not to be effective (bonus question: why what SW argues is different from SS’s obsession with NGDP targeting); and

(5) given that diagnosis, what would be the implications of increasing the expected budget deficit for this and next fiscal years and financing it (a) by issuing debt, or (b) by issuing currency (indeed, you may have to make clear whether the additional deficit is caused by increasing expenditure on goods and services, increasing expenditure on transfers, or reducing tax revenues).

Nemi August 24, 2011 at 7:21 am

I would also want to know why it matter whether the intervention is Ricardian

8 August 24, 2011 at 5:47 am

Issue Treasury debt and use the proceeds to buy physical gold from U.S. mines. If USD drops, USG can buy back more than 100% of the issued debt by swapping it for appreciating gold. Issue 30-year bonds to buy gold and use any gold sales to redeem short-term debt, improving the financial position of the government.

John Thacker August 24, 2011 at 7:10 am

How can government action mitigate the liquidity scarcity?

If the objective is to make more reserves circulate, surely the Federal Reserve could cease paying interest on reserves above the required level. Particularly since that interest is at a higher rate than the two year T-bill.

Bill Woolsey August 24, 2011 at 7:36 am

His argument against the effectiveness of quantitative easing is poor.

It only works if supply of private sector intermediation is perfectly elastic.

With standard supply curves, it is like noting that the change in quantity is less than the change in supply because a change in price leads to a change in quantity supplied.

In other words, if the Fed purchases long term bonds and issues reserves, it could be that private banks and other financial intermediaries who are funding the purchase of long term bonds with short term debt would do less of it. But only if the supply of their intermediation services is perfectly elastic, would this fully offset the impact of the Fed’s actions.

Of course, Williamson appears to believe that lowering the interest rate paid on the reserves would be highly effective. It isn’t clear to me why he thinks there is a zero bound, or rather, when the interest rate paid on reserves is suffiently negative that the quantity of excess reserves are zero and open market operations that result in an increase in currency, this wouldn’t be inflationary. I

don’t really agree, but this is similar to Sumner’s occassional fixation on currency. I think Williamson would do well to contemplate payments systems without hand-to-hand currency. It helps clear away prejudices about only currency matters, and opens up the possiblity that under the current regime, currency is less important than he appears to assume.

Oh, and finally, the first statement that zero nominal rates must imply a deflationary regime (with real rates on short and safe assets given?) is a mistake. The notion that it must be that Treasury bills provide better payments services is doubtful.

I think that all goes to Williamson’s view that the prices and wages are always at a level to keep the real quantity of money equal to the demand to hold money.

To me, the goal of quantitative easing is to raise nominal GDP back up to some kind of sensible trend. A liquidity trap would be something that makes that impossible. Williamson would appear to have no use for the goal, and so, I am not sure what tax cuts funded by short term debt is supposed to accomplish. Get people to want to work now when taxes are low (and work less later when the debts are to be paid back?)

Anon1 August 24, 2011 at 9:17 am

Bill:

Can you explain what you mean by the phrase “supply of financial intermediation is perfectly elastic” in the following paragraph:

In other words, if the Fed purchases long term bonds and issues reserves, it could be that private banks and other financial intermediaries who are funding the purchase of long term bonds with short term debt would do less of it. But only if the supply of their intermediation services is perfectly elastic, would this fully offset the impact of the Fed’s actions.

TallDave August 24, 2011 at 7:58 am

Very interesting argument. I will have to ponder it a while. Thanks for sharing.

Rahul August 24, 2011 at 8:13 am

The scarcity we are observing is not a traditional currency scarcity.

Ok, so what exactly is the current scarcity if not of currency? What else can cause a liquidity crisis?

Paul Rene Nichols August 24, 2011 at 8:55 am

Like E. Barandiaran, I’m not getting a lot of the economics jargon from this post, but I think I have the gist of it.

Traditional monetary policy increases the money supply by loaning cash to banks at low interest rates. This in turn lowers the value for banks of holding on to your money, so CD and savings account interest rates go down. But since there is more money in the system, it should be easier to get a loan or a mortgage, so people and institutions can get money and spend it, increasing economic activity.

Our problem now is that this traditional monetary policy only increases the supply of money to big institutions and wealthier, loan worthy individuals. To put it more bluntly, an unemployed father, who’s salary was at or below the median income, is not going to go out and get a $50k loan at 3% interest to feed his family for a year. So traditional monetary policy does not, in fact, increase the supply of money to the people at the bottom who need to spend it.

I’ve been thinking that what we need are direct transfer payments to working and middle class people, because at this point, cheap loans aren’t encouraging the institutions and people that would normally give the people at the bottom of the economy work.

Please correct me if I have mischaracterized anything.

The Anti-Gnostic August 24, 2011 at 11:27 am

“To put it more bluntly, an unemployed father, who’s salary was at or below the median income, is not going to go out and get a $50k loan at 3% interest to feed his family for a year.”

An unemployed father taking out a $50K loan to finance consumption would be a suicidal moron. The loan would make sense only if he uses it to finance a production factor with a positive ROI. And that gets to the heart of the problem: artificially cheap money distorts the market signals that would show which production factors will generate a positive ROI. This is how you end up with billions in capital and labor poured down the black hole of housing. Artificially cheap credit fueled demand that was unsustainable without continued infusions of artificially cheap credit. The housing ‘wealth’ that was driving all the demand was never real. Now it has vanished. Poof. Gone. There is no way out of the hangover other than to let the bad investments liquidate.

But I suppose if we’re going to make transfer payments, they should probably go to what would otherwise be downstream recipients of the new money. For example, why couldn’t the Fed have simply paid off all the underwater mortgages?

NAME REDACTED August 24, 2011 at 5:25 pm

+1

TGGP August 24, 2011 at 9:24 am

So a “New Monetarist” says monetary policy is ineffective and we need to use fiscal policy. How about the Quasi-Monetarists seize his label and he calls himself a “Not Monetarist”.

NAME REDACTED August 24, 2011 at 5:30 pm

Fiscal policy is ineffective AND monetary policy is ineffective. All monetary policy does is push back the adjustments by boosting overall demand, fiscal policy doesn’t even do that, it just increases the systematic risks for the next recession.

Floccina August 24, 2011 at 10:15 am

So if he was correct would it be good for the fed gov to buy the vanguard total market fund, a total bond market fund, maybe world wide stock and bond funds, commodity funds and land and issue short term liquid bonds to cover it? Then once un-employment drops starts they start to sell that stuff?

Floccina August 24, 2011 at 10:19 am

Is he saying that Governments bonds and currency are out competing other assets by too much?
Would a free banking system not have to deal with this problem?

Steve Williamson August 24, 2011 at 10:29 am

Tyler,

Thanks very much for reading. I appreciate it. ““Neoclassical macroeconomics” is not totally out to lunch, and it is ignored at our peril.” Yes, exactly. What you are calling “neoclassical macro” is not an ideological bludgeon, it’s a set of useful tools that can be very helpful in understanding what we can and cannot do to make the world a better place.

Steve

Jack Burton Mercer August 24, 2011 at 10:50 am

(1) Stabilize the currency
(2) Deregulate
(3) Cut federal spending by a significant amount, i.e. $500B per year

NAME REDACTED August 24, 2011 at 1:32 pm

Um, but why wouldn’t government spending decrease liquidity?

SHocking21 August 24, 2011 at 1:45 pm

Brad Delong has been saying the same thing for quite a long time. The only difference is that he comes to the sensible conclusion that if the market demands more safe, liquid assets from the government, in exchange for those liquid assets, the government should employ the cash flow to increase the supply of valuable public investments. Curious that Tyler would pick up Williamson’s piece while ignoring Delong’s continued advocacy along the same lines…

NAME REDACTED August 24, 2011 at 5:32 pm

They have it backwards. Government actions create the need for liquid assets by injecting uncertainty into the market. This in turn creates demand for treasuries and cash. Either the government shuts off the tap early or the entire system bubbles up and pops.

Michael Carroll August 31, 2011 at 4:59 pm

This is Insane. Are you saying without government there would be no uncertainty? Because you just said that government creates the need for liquid assets. Like people would prefer to carry goats around trading them for new cars or something.

Please put down the Kool-Aid.

Noah August 25, 2011 at 2:26 am

“One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.”

Isn’t this called “fiscal stimulus”? Isn’t this exactly the rationale Brad DeLong always gives for stimulus spending?

Not sure why this is being called “neoclassical”…

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