Walking into the Liquidity Trap

George Rebane

QE2 used to be the short moniker of HMS Queen Elizabeth 2, flagship of Cunard’s luxury liners.  You boarded QE2 and forgot your troubles as you were transported across The Pond with more comforts than you could imagine.  Today’s QE2 is the code word most people hear and can’t put together with anything that might affect them, let alone cause them more discomfort than they can imagine.

QE2, the second tranche of ‘quantitative easing’, is planned to pump $600B more newly printed fiat money into the economy backed by nothing but the blather of the Obama administration.  Coming from the Fed, it is intended to turn loose more money from the banks that have been using past bailouts and QE1 to fatten their reserves instead of making needed loans.  The additional money is supposed to continue to ease interest rates and maybe even revive the housing market.  Not a chance.

The real purpose of QE2 is to ‘monetize the debt’ – i.e. to continue destroying the value of the dollar so that our government’s (or should that be governments’) debts and unfunded liabilities can be paid off in worthless dollars that add to up to the quoted nominal amounts that are on the books for the Chinese, Japanese, … lenders and our legions of pensioners.  In short, it is the quiet beginning of the last stage of government make believe that all is still well with our economy.

The thing here is to note that we have entered the dreaded Keynesian ‘liquidity trap’

"There is the possibility ... that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control."  John Maynard Keynes, The General Theory.

Expanding on this, John Hussman of the Hussman Funds writes –

Alternatively, monetary policy might transmit its effect on the real economy by directly altering the quantity of funds available to lend. In that view, a liquidity trap would be characterized by the failure of real investment and output to expand in response to increases in the monetary base (currency and reserves).
 
In either case, the hallmark of a liquidity trap is that holdings of money become "infinitely elastic." As the monetary base is increased, banks, corporations, and individuals simply choose to hold onto those additional money balances, with no effect on the real economy. The typical Econ 101 chart of this is drawn in terms of "liquidity preference," that is, desired cash holdings plotted against interest rates. When interest rates are high, people choose to hold less cash because cash doesn't earn interest. As interest rates decline toward zero (and especially if the Fed chooses to pay banks interest on cash reserves, which is presently the case), there is no effective difference between holding riskless debt securities (say, Treasury bills) and riskless cash balances, so additional cash balances are simply kept idle.

 

Let me describe this trap in an even simpler way.  As interest rates approach zero, there is a critical level where everyone with money to lend says, ‘Why should I risk lending my money at such a low rate to someone who may not pay it back.  The risk is not worth the reward, so I’ll just stick it under my mattress and sleep on it until I find something better to do with it.’  After reaching this low interest rate, all additional cash injected as stimulus will just be stashed away and not put to work growing the economy.  We are almost there now, and that’s why QE2 won’t stimulate anything except the next stage of inflation.  Keep your eyes on precious metals and commodities.

Over the last years RR readers have become familiar with my warnings (here 17may08, 13oct08, 2dec08, 11jun09, 22aug09, 12sep09, 6oct09, 12dec09, 01mar10) on the tactic – pay off expensive debt with cheap money - that all spendthrift governments throughout history have attempted as their last gasp before capitulation or invasion.  I even proposed an operational monetary workaround for conducting business in an environment of ramping inflation (here).

Today the acknowledged financial pundits and world experts are finally beginning to pick up on what the revelations of Bernanke’s broken promise not to monetize the debt really mean.  Obama has openly stated that the “Fed’s mandate (is) my mandate” to devalue the dollar as part of his plan “to grow our economy”. This devaluation will be “not just good for the United States, (but) good for the world as a whole.”

Today the world’s leaders are joining in a chorus of ‘global backlash’ against the blatant risk of the coming dollar destruction and hyperinflation, with China and Russia being the latest to add their alarums to that of Germany.  The historical independence of the Fed from White House money machinations has come to an end as the President openly confirms the collusion between the administration and the Federal Reserve.

This is serious stuff for people holding dollar assets, and I’ll have much more to say about it in the coming days.  In the meantime, what would life be like if your dollar today buys a dime’s worth tomorrow?  And then it really gets bad.

Comments

[Dixon Cruickshank]

great piece George although it may go over some heads, its really hard to grasp the problem - I'll be waiting for the next installment. I got the one about the low interest rates though

[Account Deleted]

I caught a bit of Paul Krugman (Sunday, I think) explaining why the evil business owners won't hire. First, he stated that the excuse about uncertainty was a "canard" and that polling of business owners showed they would not hire because they have no customers. The customers don't exist because they can't get credit. Just print money and hand it out and all is fixed. He has a Nobel prize in economics, although creative writing would be more apt. The man is wilfully ignorant of the facts and has no clue of the basics of economic activity. His way of thinking is unfortunately winning the day at the Fed. Although he carps constantly that they are not printing money anywhere near fast enough to do any real good for the economy. BO and Ben and the rest of that crowd are playing checkers with the economy while reality plays chess. Most of QE1 and now QE2 is going into an over-heated stock market and commodities market. A weak dollar seems a great idea to all who have no understanding of history. It has never worked and usually leads to trade wars and worse. The Fed wants me to see inflation coming and shake loose of my cash - thereby stimulating the economy and happy days will be here again. Unfortunately it does not change any of the original reasons that I was in cash in the first place. It only forces me to make a less bad choice of what to do with my money. Buying gold does not stimulate our national economy much at all. At 1400 an ounce, Nevada County should be at zero unemployment, but we seem to have a deadly fear of actually producing anything here beyond hazily described green jobs. Wealth only comes from producing goods that are wanted by a free market. Nothing else will work in the long run. But as Bill Clinton said -"you don't know how to spend your money".

[Michael Anderson]

Scott, we actually produce an amazing amount of goods and services in Nevada County. We are not suffering anywhere nearly as much as are so many counties in the Central Valley.

All of this Chicken Little stuff from you guys is starting to wear me out...

[Dave C]

Guest analysts on CNBC believe QE2 could reach $1.5T if the initial $600B ante fails to curb deflation. But, that is their opinion. If this happens, the launching of QE2 may well be the launching of the Titanic.

[Todd Juvinall]

Nevada County has a high unemployment rate and it will remain so for a lot of quarters. There may be a few spots in the business world less affected but the bulk of jobs are just not there. Bernake is afraid of deflation but I think the inflation risk is even greater. Inflation, as we saw in the late 70's early 80's, made a mockery of a person's paycheck. In my view, I think this financial stuff is guessing at best.

Nevada County became the bedroom community I and many others in business fought hard to defeat. We lost and the no growth, eco nuts won.

[D. King]

"We are not suffering anywhere nearly as much as are so many counties in the Central Valley."

Really?

Oh, thanks Michael, I almost forgot about the
Central Valley's Farmers who had their water
shut off for the Delta Smelt.
You’ll should be thankful, because others are suffering
more!

At $1400.00 per once, we should open up a mine...
oh wait, we tried that...shoot. Well at least
we can count on AB32 to create a mountain
of "Green Jobs" installing Chinese solar panels.
Between the Feds, state and local government,
I can’t tell if this is simple incompetence or a
nefarious plan. But then there is this to help
me decide.

http://www.youtube.com/watch?v=3ZEv1T15RcY

George, I think we’re in the S.S Minnow, not the QE2.

[Account Deleted]

Chicken Little stuff? I'm sorry that reality is tiring Michael. I'm sure that somewhere, some one is suffering even more, so we're just fine here. Crank the printing press speed control to 11 and have a nice nap.

[Russ Steele]

JOHN PODHORETZ: The real fear in QE2.

I can’t write with any authority on the macroeconomic wisdom of the decision to do a second round of “quantitative easing” — a move nautically dubbed QE2. (The first round came in March 2009.)

But whether you think it’s a sound or unwise action — and people I trust are inclined to think it’s a disaster — QE2 is a deeply disturbing sign: It suggests that we have reached the outer limit of what experts actually know about the condition of the American economy in the wake of the 2008 financial meltdown and how to repair it. . . .

Even the Fed and its chairman Ben Bernanke know they have undertaken something very risky.

The obvious risk is that, by suggesting that the United States may try to escape its economic doldrums via the monetary printing press, it will create an inflationary spiral and destroy confidence in the stability of US currency.

The less obvious risk is that QE2 will prove ineffectual. If it doesn’t move the needle on the economy at all, but rather seems simply to fall into a black hole, that will confirm the unnerving and growing sense that we are headed for an extraordinarily extended period of extraordinarily low growth and extraordinarily high unemployment.

Why is spending the only solution, why not cut taxes and stop spending?

[Mikey McD]

Great summary George. Keynes' ultimate answer was "in the long run we are all dead." How comforting.

In re-reading Hayek's Road to Serfdom last night I was again re-reminded of how ill conceived our politicians/planners actions are, have always been and ever will be. The anti-liberty acts of 1913 (Fed Reserve Act and 16th Amendment) set the foundation for what ails us 100 years later. Attempts at manipulation will continue to fail...

What would the free market do?
Sang to the tune of John Lennon's Imagine

Imagine there's no Fed
It's easy if you try
No Planners above us
Above us only sky

Imagine all the people
living free today...

Imagine there's no progressive tax
It isn't hard to do
Equality in liberty
Not equality in servitude

Imagine all the people
living free today...

[Todd Juvinall]

OMG! It looks like a hockey stick!

[Michael Anderson]

Since y'all love Krugman so much, I thought you might like to read his latest on gov't spending here: http://www.nytimes.com/2010/11/01/opinion/01krugman.html?_r=1&ref=opinion

[George Rebane]

A mind boggles, Krugman should open a book on the Depression. What was his Nobel for again?

[Mikey McD]

I think Krugman's Nobel was for the "Children's Stories" category... you know, the ones that always have a happy ending via defying logic.