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Liquidity Trap

April 9, 2013

Liquidity Trap

In response to my last blog post “Playing high tide in the bath tub,” one of my readers commented, asking me what I thought of this article. Another reader (my good friend Wayne) responded and did a good job assessing the issues referenced in the article.

One thing I would add is that I believe so much of what we read these days is theatrics.

What I mean is that I have read many articles or listened to financial commentators that make it sound like there is a sane way out of this mess; that our monetary policy is working as planned. This might make the average investor believe everything is still in control but the reality is that this is all a grand experiment. The Fed and even most of our economists do not have a clue how this will turn out. This is not to say that I know how this ends — I don’t — but I think it is not unreasonable to have some questions about whether this massive manipulation will turn out well.

Case in point, the above article says, “At some point as the economy normalizes, most likely around 2015, according to the Fed’s current view, the Fed will wish to begin tightening monetary policy in order to prevent the exceptional level of liquidity in the banking system from feeding into inflation.” Reading this sentence should make us feel that everything will still return to normal, whatever ‘normal’ is.

We are in the greatest economic experiment in our entire history. We are currently keeping economic consequences in abeyance, but we are also ensuring that our economy will not “normalize” because of all the liquidity.

First, let’s look at the following “official” definition of liquidity trap, from Wikipedia:

A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

In our present situation, the Fed has made sure that interest rates are lower than they have ever been by means of being the largest purchaser of government and mortgage debt instruments. They have succeeded in driving up many, if not nearly every, investment instrument, including real estate and equity markets. But they have created a ticking time bomb, particularly in the bond market. Their efforts have stimulated Wall Street but not the economy as a whole. So the traditional definition of liquidity trap above is not the case now. The Fed has done this interest rate manipulation to an extreme. And if equity markets were the measure of a recovering economy, they would be considered very successful.

The economic activity the Fed has created is relegated to financial markets with just a little rollover into the economy as a whole. I think they know that they can’t afford not to grow their liquidity (printing and purchasing), much less begin to reduce it, without creating some level of panic in the markets. Printing and purchasing is the only game the Fed knows and it is the only thing that is keeping this current “economic recovery” afloat. Can we withstand an end to the experiment, much less the beginning contraction by withdrawing the liquidity out of the economy? This is the multi-trillion dollar question.

The theory I have for why their policies are failing is that the medicine they are supplying, which is to encourage more debt and consumption, is the very same reason our economy became sick in the first place. Easy money increased our debt-driven consumption until we arrived at the 2008 credit (debt) crisis. They are now compounding the problem. But even worse is the fact I think they are creating a new kind of liquidity trap. There is no way to escape what they have done, but they must give the illusion that they have an “exit strategy.” Hence, the reason/purpose for the numerous stories we see of just how the Fed will exit this experiment. Part of the whole façade is pretending that the Fed is working on an exit strategy, because if they didn’t pretend to be doing this, some of us might begin to wise up and declare the emperor has no clothes on.

Hey, I have to keep this "G" rated!

Hey, I have to keep this “G” rated!

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