Liquidity Trap

Guys, from nearly two months, I am writing in my blog that US may be heading for liquidity trap. Also many time I mentioned about helicopter money.

Today, in Financial Express, Editor also expressed the same thing. Here is what Financial Express says…

ECONOMIC recession is usually defined in textbooks as two consecutive quarters of declining output. On Monday, the NBER (National Bureau of Economic Research) has said that the US has actually been in recession since the end of 2007. What is worse is the consistent decline in economic performance despite a slew of proactive policy measures—fiscal and monetary—initiated by the US government.

There is now a serious danger of the US being in a liquidity trap, where interest rates and monetary policy lose all potency. Interest rates have been slashed to as low as 1% and there isn’t long to go before they hit zero. Still, borrowing and lending are in a stall. People are simply hoarding up on cash in a low-confidence environment. Japan suffered for almost a whole decade because of a liquidity trap. The US and the rest of the world can ill-afford such a prolonged slowdown in the world’s largest economy. In the absence of monetary policy—we are yet to see Ben Bernanke offload helicopters of money to ward off a liquidity trap—fiscal policy gains additional importance. Unfortunately, the US presidential transition has come at a bad time from an economic point of view. The new President and his team don’t take office until January 20, 2009, still a month-and-a-half away. The current government doesn’t have the authority to plan and implement a large fiscal stimulus. Under the circumstances, things could deteriorate rapidly in the interim if a fiscal package is not announced. In the meanwhile, there is no consensus on the future of Detroit’s carmakers either. Given the extraordinary circumstances, American politicians from across the aisle in Congress and across two presidencies must get their act together faster. The global economy may pay a heavy price for US inaction.

On 27/09/2008 I expressed the same thing in blog. Here is what I said at that time…

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 all this, whole world stock markets 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