Stephen Williamson on the intuition behind liquidity traps and inflation

by on December 4, 2013 at 1:45 pm in Economics | Permalink

He writes:

Next, conduct a thought experiment. What happens if there is an increase in the aggregate stock of liquid assets, say because the Treasury issues more debt? This will in general reduce liquidity premia on all assets, including money and short term debt. But we’re in a liquidity trap, and the rates of return on money and short-term government debt are both minus the rate of inflation. Since the liquidity payoffs on money and short-term government debt have gone down, in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up. That is, the inflation rate must go down. Going in the other direction, a reduction in the aggregate stock of liquid assets makes the inflation rate go up.

Do read the rest for the full picture.  I understand how this works if one postulates a strict equality between (risk-adjusted?) rates of return on currency, T-Bills, and other assets in the economy.  But given current T-Bill and inflation rates, that is going to mean negative real rates of return on a variety of other physical assets, which I take to be at variance with some rather overwhelming data to the contrary, including stock market returns, internal hurdle rates at corporations, investment trends, measured profits, asset prices, and so on.  I also fully endorse Scott Sumner’s point that short-term asset price and exchange rate reactions to QE pretty clearly show it is expansionary, although by how much is arguably not clear.

The most likely alternative, in my view, is that some kind of funny asset market segmentation is going on, and that risk premia and collateral demands for T-bills are high in funny ways, so that (risk-adjusted?) rates of return are not so strictly negative all over.  What that means concretely is that if the Treasury issues more debt and liquidity premia on debt fall, there is not an offsetting shift in the rate of price inflation to restore the previous set of relationships across asset returns; rather some of the incidence of the quantity change falls on T-Bill returns themselves.  I have yet to see that well-modeled and do not have a preferred approach of my own which will in some simple way preserve a zero profit condition.  (We also may need to talk about knife edge conditions and whether these rate of return equalities must be truly and exactly equal for the model to work, besides how well do we understand the substitutability of money and T-Bills anyway?)  Williamson may damn me for that non-foundational approach, but I see that as the least indefensible answer to this question given our current state of knowledge.

I like many of Williamson points in macro, but in general I prefer to put the empirical evidence in the driver’s seat more than he does.  He does write:

What’s the qualification [to my argument]?  There are various short-run effects of monetary policy that could come into play. However, I think it’s fair to argue that any of those short run effects have played themselves out in the financial crisis and its aftermath, and now we’re looking at the effects I’ve described.

That’s the right question, but it’s not nearly a close enough engagement with the evidence, which does pretty clearly show some short-run effects are still operating, even if those effects are diminishing with time.  The evidence also does not clearly indicate that the long-run effects (e.g., check out the term structure of interest rates) have to move in the direction Williamson is indicating.

It’s still a puzzle exactly what is going on, but we need to be very careful about how we use the overly seductive argument from elimination.  When in doubt, reread David Hume.

Addendum: I do get Scott’s and Yichuan Wang’s argument about the hot potato effect for monetary injections, but I am not sure this can handle the case of an increase in the supply of Treasury securities.  Go back to my earlier remark about how little we understand money-T-Bill substitutability.

And here is more from Williamson.

1 dearieme December 4, 2013 at 2:01 pm

“the rates of return on money and short-term government debt are both minus the rate of inflation”: eh? What’s that in English?

2 Joseph Ward December 4, 2013 at 2:06 pm

He’s just talking about real interest rates versus nominal interest rates.

3 dearieme December 4, 2013 at 3:38 pm

Thanks: but what’s his objection to doing so in English?

4 Adrian Ratnapala December 4, 2013 at 10:09 pm

Dude, that was one of the few things the article that I did understand.

5 honeyoak December 4, 2013 at 2:17 pm

How can you model an instantaneous increase in the supply of treasuries without modelling what is done with the money? Unless the government is burning the money one will need to model the simultaneous draining of private sector liquidity to buy the bonds.

6 mulp December 4, 2013 at 8:37 pm

What evidence of reduced private sector liquidity? All the evidence indicates the private sector liquidity has increased faster and faster as more and more debt is issued – why else would share prices be rising so rapidly at the same time the supply of Treasuries at near 0% has exploded?

And just think, in 2001, Alan Greenspan correctly predicted a rising demand for US Treasuries in supporting a reversal of Clinton’s budget policy of paying off the public held debt by 2010 or so.

7 ummm December 4, 2013 at 2:42 pm

Agree with Tyler and Scott Sumner. Not only has QE been inflationary as evidenced by rising stock prices but would also add that the program has been a huge success in other ways such as reducing borrowing costs for M&A, buybacks by reducing longer term yields.

8 Michael December 4, 2013 at 3:40 pm
9 Nick Rowe December 4, 2013 at 2:59 pm

Tyler: ” I do get Scott’s and Yichuan Wang’s argument about the hot potato effect for monetary injections, but I am not sure this can handle the case of an increase in the supply of Treasury securities.”

It can handle it easily.

Assume that bonds and money are perfect substitutes. The public has a demand for (B+M)/P. If the Treasury increases B, there is now an excess supply of B+M at the given P. So people will try to spend their excess B+M, which creates an excess demand for goods, which raises P, which reduces (B+M)/P back to its original equilibrium value.

(And if the bonds are indexed bonds, the argument is similar, except the public has a demand for B+(M/P) ).

My response is here: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/12/helicopter-money-does-not-cause-deflation.html

10 Tyler Cowen December 4, 2013 at 3:10 pm

But I don’t think we should assume they are perfect substitutes, not right now at least…

11 GF December 4, 2013 at 3:19 pm

Is SW not forgetting that instead of the inflation going down, the prices of other assets can just go up reducing their return? He’s assuming the absolute return must go up, when it’s the relative return that matters!

12 Nick Rowe December 4, 2013 at 3:28 pm

Tyler: OK, let’s assume they are imperfect substitutes. The stock of B increases, which reduces the marginal benefits of the liquidity services of M/P. (Steve Williamson says this himself). The rest of my argument continues as before. People have an excess supply of money at existing prices.

Furthermore, if Steve’s argument were correct, it would apply equally well to a helicopter increase in *any* liquid asset, like money. A helicopter drop of money would cause the inflation rate to decrease to restore equilibrium, on or off the ZLB, when an increase in the price level could (and would) also restore equilibrium.

Furthermore, as Bob Murphy shows, starting from zero inflation, and increase in the growth rate of the money supply would cause ever increasing deflation, if Steve Williamson was right.

This therefore explains why Zimbabwe had hyperdeflation — a fact that had always puzzled me before.

13 Keith Lewis December 4, 2013 at 3:32 pm

I don’t think we can assume that T-Bills and cash are ever going to be strictly equal. Introducing extra treasuries securities would only be a quick fix and the effects would diminish quickly.

14 Willitts December 4, 2013 at 7:17 pm

The preeminant minds in the profession cannot agree on whether printing money will increase or decrease inflation, yet we have been engaged in multi-trillion dollar asset purchases in an attempt to apply the knowledge of the field to practical use in steering the economy.

We…are…so…screwed!

15 Steve Williamson December 4, 2013 at 10:25 pm

“…but it’s not nearly a close enough engagement with the evidence, which does pretty clearly show some short-run effects are still operating, even if those effects are diminishing with time.”

I’d be curious to know what “evidence” it is that “clearly” shows this. My guess is you’re making this up.

16 Steve Williamson December 4, 2013 at 10:28 pm

“Williamson may damn me for that non-foundational approach”

You bet.

“some kind of funny asset market segmentation is going on, and that risk premia and collateral demands for T-bills are high in funny ways”

Be specific. What kind of funny stuff is this that is going on?

17 Ray Lopez 'disses' Williamson by posting under his post December 4, 2013 at 11:40 pm

By posting in a reply I’m stealing your thunder Williamson. Bet you’re pissed. The “funny stuff” could be simply the fact that banks collect a small rate of return from the Fed for doing nothing but holding QE money. This is deflationary, according to researchers at the St. Louis Fed:

http://research.stlouisfed.org/pageone-economics/uploads/newsletter/2011/201104_ClassroomEdition.pdf

Critics of QE warn that because QE increases the monetary base significantly, dramatic inflation could result. Currently, banks hold a large amount of reserves, which constitutes the largest component of the monetary base. If banks were to loan these reserves, they would effectively increase the money supply. If the money supply were to grow at a rapid rate, the resulting increase in economic activity could cause infla-tion to accelerate and expectations of future inflation to increase. The Fed, however, remains confident that its programs, including incentives for banks to retain their reserves, will prevent such an outcome. For example, the Fed pays banks interest on reserves at Fed banks. If the interest rate on these reserves is higher than the return banks could receive from alternative investments (the banks’ opportunity cost), reserves will remain idle

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21 Brian December 8, 2013 at 9:56 pm

“in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up.”

Can anyone explain the mechanism that would make this statement true?

Normally an increase in yield (or expected rate of return) is effected by a decline in price. But the dollar in my pocket is always priced at par. I can choose not to hold the dollar, by converting it to other assets, but that doesn’t reduce the price of money (increase its yield) directly or, apparently, indirectly either.

If I’m induced to convert my dollar to other assets that increases the demand for those other assets. Shouldn’t that also increase their price? And isn’t that inflationary? How can it work any other way?

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