I want to follow up a little on my discussion of the liquidity trap that we are have been in. Brad Delong has an excellent post today called “Four Years After the Wakeup Call”. In it he shows some graphs which illustrate very well our the liquidity trap.
Delong first serves us two graphs on the Federal Funds rate since early 2007:
The daily gyrations of the usually-placid Federal Funds market starting in late 2007 told us all that banks were really worried that other banks had jumped the shark and turned themselves insolvent.
The Federal Funds rate is the interest rate that banks pay to each other when they borrow reserves from each other. Despite the name, the rate isn’t set by The Fed. It’s set by market supply-and-demand. It’s a large and brisk market. When the Fed Funds rate is high (or at least rising), we can infer that banks need and are desperate for reserves, typically because they have profitable opportunities to make loans based on those reserves. When The Fed Funds rate is low and/or dropping, it means that a lot of banks have excess cash on their hands and don’t see any useful or profitable ways to use that money. In other words, a low Fed Funds rate means banks are willing to lend their reserves to other banks because it’s better than nothing and they don’t see any good ways to loan out the money. At the same time, a low rate also shows that few banks are interested in borrowing – again because they don’t see much useful to do with it. While The Federal Reserve doesn’t set the funds rate, it does set the interest rate for the alternative: direct borrowing from The Fed.
What we see from the first graph is that things were cruising along in early 2007 and then mid- to late 2007 (August to be exact), the rate starts dropping. We’re moving toward a recession. Banks are finding it harder to make good loans so they don’t want to borrow more reserves. Banks start hoarding their cash and assets. So instead of balance sheets that are full of loans, bonds, and securities, the banks decide they want/need more cash. Their reserves grow in order to provide a cushion for what was then being seen as the inevitable losses on mortgages and mortgage securities. Things appear to stablize and then in Sept 2008 comes the Lehman moment. Fed Funds rate goes virtually to zero. It’s been stuck there ever since. Banks have plenty of reserves. They have the cash to lend. There’s no willingness to lend (banks don’t see many credit-worthy borrowers) and there’s little interest or demand to borrow.
The Federal Reserve has responded during the same period by creating new base money like crazy. [NOTE: Contrary to the fears of the inflation-fearful crowd, it's not really "money" until it's in circulation with the public. It's only bank reserves - the monetary base. It creates the ability to create money for the public, but that would necessitate having a bank lend it first. ] Again Delong shows up graphically just how The Fed has been willing to create new monetary base:
And while the Federal Reserve has taken the monetary base to previously-unimaginable levels–up from $900 billion to $1.7 trillion in late 2008, up to $2 trillion in let 209, and up to $2.7 trillion in early 2011–it has never adopted Milton Friedman’s recommended policy that it start buying bonds for cash and keep buying bonds for cash until nominal spending is on the path that the Federal Reserve wants it to be on:
We only need one more graph: GDP. More precisely a comparison of GDP to an estimate of what GDP could be if we were at full employment and operating at our long-term trend. Again Delong:
And so right now nominal GDP is $15 trillion/year when it ought to be $16.7 trillion/year:
I’ll save inserting the employment graph here. I’m sure you all know what it looks like. Same story.
And that story is that we had signs of trouble 4 years ago. Three years ago things went really into the tank. The economy seriously declined until mid-2009. Ever since then, it’s struggled to hold on. There really isn’t any recovery. It’s just going sideways. We have, in effect, taken a huge chunk of the economy, a huge number of workers, put them on the sideline and said “we’re not interested in you participatin anymore. We don’t want or need your contribution. We’re happy being smaller”.
So we’ve had monetary stimulus efforts, we’ve had low interest rates, we’ve had the central bank create base money. There’s plenty of cash out there. But it’s all in the banks. It’s in deposit accounts. It’s in reserves. It’s not working. It’s not being used to buy things. It’s not being used for consumption or investment. It’s just sitting around impotent. That’s a liquidity trap.
Mainstream economic theory, the stuff called “New Classical” or “New Keynesian” (never confuse “New Keynesian” as being “Keynesian”), says keeping interest rates this low for this long would /should fix everything by now. For over 30 years now, the dominant, orthodox view in the academic and professional world of economists has been that monetary policy exercised by a wise central bank can fix all. Any weakness in the economy can be solved via lowering interest rates and having the central bank create new bank reserves. These “modern” theories told us that the concept of a “liquidity trap” was nonsense, a relic of some past era and/or the invention of some crank called Keynes. These theories claimed that everybody was perfectly rational, all markets (particularly financial markets) were efficient, and uncertainty/risk about the future was unimportant. They were wrong. We are left with the ideas of the mid-20th century, the stuff that we were told to forget about. Again Delong:
Four years ago nearly all mainstream economists would have said that, even though the situation appeared serious, by now the economy would be back to normal. …
Very few of us thought that it would be long and nasty…
And as it turned out to be long and nasty, recent economic theories of macroeconomics have fallen like tropical rain forests. The–already implausible–claims that downturns had real causes? Fallen. The claim that downturns lasted only as long as workers misperceived their real wage? Fallen. The claim that the labor market cleared in a small number of years? Fallen. Those of us who believed that the long run came soon, that the cause of downturns was transitory price-level misperceptions, or that downturns had real causes need now to be looking for new jobs, or at least new theories.
And we are left with the live macroeconomic theories being those of the 1960s, at the latest. This is embarrassing for those of us who want to belong to a profession that is a progressive science, rather than an analogue of medieval barbering.
So what would the economic theories of the 1960s and before tell us to do?
- Milton Friedman: monetary expansion, and more monetary expansion–quantitative easing as deep and as broad as necessary to get nominal GDP back to its trend.
- John Maynard Keynes (or at least one of the moods of Keynes): have the government borrow and buy stuff, and keep buying stuff until real economic activity is back to some normal trend value.
- Jacob Viner: Why choose? Do both! Print lots of money and have the government use it to buy stuff and hire people.
The odd thing is that none of those three recommended policies–all of which are sponsored by economists with the purest of purebred pedigrees–have been followed.
It’s time to do two things. At the policy level we need to go back and try the policies that we understood back in the 50′s and 60′s (economy did pretty well back then, BTW). Some serious, bold attempts at effective government spending would be nice instead of the weak, too-small, too-timid, niggling efforts dominated by tax cuts we’ve been doing. And even on the monetary front, it would be more useful to do as Friedman suggested: actually have The Fed keep buying bonds for cash (real circulating money instead of just bank reserves) and keep it up until people start spending it.
On the economics side, we need to get past the perfect rationality and rational expectations stuff (and it’s absurd mathematics) that has dominated the profession. It would be a good idea to take a more serious look at the heterodox ideas and theories that actually did foresee the crash, the ones based upon realistic models of human behavior and models instead of the perfectly rational, knows-the-future home economicus of the New Classical and New Keynesian models. We need to seriously look at ideas of Modern Monetary Theorists (MMT), Minsky, the Post-Keynesians, and the behavioral economists.
