The Liquidity Trap, has cheap credit trapped our economy like a fly in sap?

This post is an amalgamation of the opinions and writings of economists on the liberal (Keynes) and conservative (Hayek) schools of thought. Some will be straight up Kenesian desciples, some from the Chicago School (like Milton Friedman) and some from the Austrian school (Robert P. Murphy).

Paul Krugman is not my favorite economist, but back in 1998 he co-authored a paper on the Liquidity Trap.

A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible price, full-employment economy; and although any reasonable model of the United States in the 1930s or Japan in the 1990s must invoke some form of price stickiness, one can think of the unemployment and output slump that occurs under such circumstances as what happens when an economy is trying to have deflation-a deflationary tendency that monetary expansion is powerless to prevent.
So how is a liquidity trap possible? The answer lies in a little-noticed escape clause in the standard argument for monetary neutrality: an increase in the money supply in the current and all future periods will raise prices in the same proportion. There is no corresponding argument that a rise in the money supply that is not expected to be sustained will raise prices equiproportionally-or indeed at all.

In short, approaching the question from this high level of abstraction suggests that a liquidity trap involves a kind of credibility problem. monetary expansion that the market expects to be sustained (that is, matched by equiproportional expansions in all future periods) will always work, whatever structural problems the economy might have; if monetary expansion does not work-if there is a liquidity trap-it must be because the public does not expect it to be sustained.

It’s not easy reading as the discussion of various economic models is the bulk of the paper but it is quite obvious that the “Liquidity Trap” is fully upon us in the same manner that Japan’s “Lost Decade” came about. We find ourselves no at a time when any move by the Fed to exit out of the QE strategy is met with market downturns, and yet there is no more talk of injecting even more cash into the system, nor raising interest rates.

Simply pumping money into an economic system to push inflation works just like pumping air into a balloon causes it to inflate. However what if the balloon is not structurally sound? You can pump in air all you want but if the balloon has holes you will see no growth, or you won’t see the growth you should for the amount you pump in. This is a poor analogy because a balloon represents a closed system and the US economy is NOT a closed system. It is important to remember that all analogies have some imperfection, so as long as you understand that when the system isn’t working like it should simply pumping more stuff into it won’t give you the result you want.

Right now “The Fed” is pushing out the idea that negative interest rates are coming (like they already have in Europe) and you have the conservative economists taking a hard look at the data: and even mainstream publications are talking about another recession in the recovery:

So to use another imperfect analogy, we are at the point where a lack of money isn’t the the problem. The excess of money became cheap credit, so now we are in another credit bubble. Except instead of mortgage backed securities (which are STILL around and on the balance sheets of the Fed Reserve) we have a bubble of corporate and government debt. But we also have an economy that apparently can’t take the shock of an interest rate hike because no one is making enough money to absorb higher payments and higher interest.

So what can the Fed do? Well there are really only things that the Fed can do, buy/sell debt or raise/lower interest rates. All the additional debt taken on by the Fed is just getting rolled over, so buying/selling debt at this point is a no-go, the monetary base has been expanded to the point where further expansion is pointless. Raising or lowering interest rates is a much touchier subject, right now the economy seems to be running on cheap credit, so any threat to raise interest rates sends the stock market tumbling ahead of the proposed rate hike. So neither tool the Fed has is appropriate.

So will it be hyper-inflation? Probably not, it’s a possibility but I just don’t think it’s likely. Will it be recession? I think that is a higher possibility, even with cheap oil the economic downturn in China and the ongoing chaos with Russia and the Middle East don’t seem to be a good environment for international demand leading to domestic economic growth. Will it be more of the same? Some sort of “stag-flation” where the economy just sort of bumbles along and inflation eats away peoples savings? I think this is most likely.

Now the economist who most opposes Krugman has to be Robert P. Murphy Ph.D. went ahead and did a talk about the current situation that I think is worth watching.

Just because one pundit doesn’t the truth make, the fact that the Fed has been driving the stock market seems to be accepted by more than just one guy: of course this flied directly against what Krugman wrote three years ago, that there was no stock bubble: and then again, even if there was a stock bubble the Fed shouldn’t care about that at all and should just let bubbles pop or deflate naturally:

Remember that even Milton Friedman thought that the great depression was caused in part by a lack of liquidity, and yet here we are in an economy that looks very much like the “Liquidity Trap” described by Krugman in his 1998 paper.Yes, this is really an interesting time to live in:

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