Ah, the elusive liquidity trap. Does it exist? Is it here? And what does it mean for monetary policy?
Those are critical questions which are not currently being addressed by policymakers, according to a new paper by Paul McCulley and Zoltan Pozsar, presented at the Banque of France on March 26. In fact, many policymakers, they say, are still under the mistaken belief that no such thing as a liquidity trap exists.
So what counts as a liquidity trap?
The authors see it as the following:
A liquidity trap is a circumstance in which the private sector is deleveraging in the wake of enduring negative animal spirits caused by the bursting of joint asset price and credit bubbles that leave private sector balance sheets severely damaged. In a liquidity trap the animal spirits of the private sector cannot be revived by a reduction in short-term interest rates because there is no demand for credit. This effectively means that conventional monetary policy does not work in a liquidity trap.
The point here is that conventional monetary policy cannot work because the economy’s demand for credit is saturated. In a liquidity trap, the transmission mechanism becomes broken.
The other point the authors hint at strongly is that central bankers like Ben Bernanke are accutely aware of this fact — and you just have to read Bernanke’s 2003 paper on Japan’s deflation to understand that. The reason central bankers will never admit it, however, is because to do so would be to admit irrelevance.
That’s not to say that the economy should stop the deleveraging process to revive the transmission mechanism. The authors are quite specific about this. Deleveraging is a necessary step for a self-sustaining economic recovery to take place. However, as they explain, it’s a burden that capitalism cannot bear alone:
At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.
Which is why fiscal austerity is the absolutely wrong ‘medicine’ for the system’s ails. Even in a world where governments are over indebted on a multiple level, austerity can and only ever will lead to economic suicide.
Which may sound counterintuitive…
…but, liquidity trap = going through the looking glass.
In this “topsy-turvy” world, traditional textbook orthodoxies, the authors argue, do not apply. Simply put, inflation cannot and will not ever be the problem. Cooperation between the fiscal authority and the central bank, on the other hand, becomes essential — even if it comes at the cost of central bank independence.
Or as they put it:
Crowding out, overheating and rising interest rates are also not likely to be a problem as there is no competition for funds from the private sector. For evidence, look no further than the impact of government borrowing on long-term interest rates in the U.S. during the Great Depression, or more recently, Japan. A buyers’ strike is also unlikely, especially in the case of the U.S. This is because countries with mercantilist policies tied to the U.S. dollar are de facto piggybacking on the U.S.’s internal demand, and simply have no option but to continue to accumulate U.S. Treasuries to moderate the real appreciation of their exchange rates so as to hold their shares of U.S. demand.
Which is why, they say, the operational mandate of a central bank operating in a liquidity trap environment should be changed materially.
Rather than “policing the government to keep it from borrowing too much” the central bank should help it “to borrow and invest by targeting to keep long-term interest rates low by monetizing debt, with the aim of killing the fat tail risks of deflation and depression.”
The interests of the fiscal authority and the monetary authority rightfully become entwined. What’s more, the loss of the central bank’s independence should not be seen as a concern.
Meanwhile, with respect to QE (a.k.a money printing), the authors note:
Critics invoke the orthodoxy that printing money is inflationary. But in a liquidity trap it is not. Money is as money does, and judging from the trillions in excess reserves on banks’ balance sheets, money isn’t doing anything. Printed money is unlikely to become inflationary until after the private sector has finished deleveraging and is bidding for funds again.
That’s to say, the real agenda of QE has and always will be to monetize debt so as to create an environment that gives governments a license to borrow — mainly by keeping long-term interest rates low. A bit of inflation, meanwhile — if it occurs — should be considered a welcome side-effect.
More importantly still, QE also helps to reduce the debt-to-GDP ratio because debt held by central banks is excluded from debt-to-GDP calculations. Once debt enters the central bank balance sheet it becomes the equivalent of money (reserves). That means crisis spending and funding can easily be carried off the public balance sheet, without any material impact on the overall debt-to-GDP ratio.
In fact, Bernanke himself noted as much in 2003:
In such a case, the government’s concerns about the outstanding stock of debt are mitigated as the quantity of debt in the hands of the public would remain unchanged and debt-to-GDP ratios would not rise. Moreover, by replacing interest-bearing debt with money, central bank purchases of government debt would lower current deficits and interest burdens and thus expectations of future tax obligations. The fiscal authority’s Concerns of Ricardian equivalence, crowding out and rising rates would be allayed, and the monetary authority’s problem would also be solved in that the government would help repair the broken monetary transmission mechanism by becoming the willing borrower to take advantage of low rates and borrow and invest
In short, the central bank must act irresponsibly and counter-intuitively, without actually spelling out that this is the case — since the risk of being misunderstood runs far too high.
Think of it as Ben Bernanke being gagged on saying what he really thinks. All he can do is play Jedi mindtricks. Hint very strongly. Or engage in Fed doublespeak. Luckily for us, a public record outlining Bernanke’s real thinking about what to do in exactly this sort of situation already exists.
And based on that thinking alone, the following interpretation of Fed actions and communications can be made.
On the Fed’s commitment to low rates to 2014 = read invitation to the Treasury to keep borrowing because the Fed won’t move rates.
On promoting principal forgiveness = read the Fed asking for policies which would inflict losses on its own RMBS holdings.
On the exit strategy = is there really an exit plan? An exit strategy implies “unprinting” and/or selling bonds. As we ourselves have noted, the latter could prove paradoxically inflationary even though the process is usually associated with a tightening policy. But who’s to say the plan wasn’t for the Fed balance sheet to stay elevated all along. Or for the Fed to hold the debt to maturity?
As an aside, the authors provide plenty of historical examples where orthodox policy (which didn’t account for a topsy-turvy liquidity trap world) led to economic disaster, and where unorthodox and ‘irresponsible’ policy led to economic success.
You can check out the full paper here. It’s certainly thought-provoking.