Liquidity Trap

First my belated birthday wishes to our Prime Minister Mr. Manmohan Singh. Yesterday he celebrated his 76th birthday. And today in our college three of my friends are celebrating their birthdays namely my room partner-Amit Chauhan, Secretary- Anurag and Brarji. Wishing all the very best of luck in their future, let’s start our usual business…

Day before yesterday I said that now RBI should start thinking about interest reduction. What do you think about US guys? What FED should do? Whether to keep it same as of present 2% or increase or decrease? Since while browsing through Bloomberg, I read that FED Chief Mr. Bernanke is hinting about reduction in Fed rate.

But I don’t think it’s a good move. Already they have reduced nearly 300-350 basis points. Presently Fed rate is 2%. By reducing the Fed rate he wants to boost the sentiments of the investors and Wall Street participants. But in this kind of situation it may act as negative news to the markets. First their financial institutions are bleeding like anything due to lack of strict regulations. Companies which are as old as 100 -200 years are going bankrupt due to excessive leveraging nearly 30-40 times of their assets. Yesterday Washington Mutual Inc. a holding company for the savings and loan that became the biggest U.S. bank to fail filed for bankruptcy protection along with its unit WMI Investment Corp.

Due to this, whole world stock market are crashed from their peak level for example Chinese market crashed nearly 45%, India almost 40% and so on. Now my point is they can’t reduce interest too low which may lead to possibility of liquidity trap.

Okay let me give brief idea about what is liquidity trap!!!

In economics, a liquidity trap occurs when the nominal interest rate is close to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they start hoarding their assets rather than making long-term investments. This makes the recession even more severe, and can contribute to deflation also.

In normal times, the monetary authorities can stimulate the economy by lowering interest rates or increasing the monetary base. Either action should increase borrowing and lending, consumption, and fixed investment. When the relevant interest rate is already at or near zero, the monetary authority cannot lower it to stimulate the economy.

Keynes is usually considered as the inventor of the liquidity-trap theory. In his view, financial participants fear the possibility of suffering capital losses on non-money assets and thus hold money instead. For example, the fear of default on loans can inhibit lenders from lending except to extremely credit-worthy customers. These fears are most likely after a financial crisis such as that associated with the Stock Market Crash of 1929. Further, if nominal interest rates are extremely low, there is no place for them to go but up. That implies that bond prices will likely fall in the near future, causing capital losses. Bond rates down means no (or less) long term investments. If investment start reducing then development will be hampered which leads to less demand leading to less production and overall leading to deflation

For your information guys, in Great Depression time, U.S. stock market fell from 1929 peak levels to 90% by 1931-32.

So present condition is almost same as that of Great Depression of 1929. Some other time I will post about the great depression and other crashes which rocked us.

So instead altering Fed rates, Fed need to think of how to get out of this present condition as early as possible and try to make the lending, leveraging & securitization regulations stricter.




Reference…

Bloomberg.com
Wikipedia.com