Remember the Keynesian Liquidity Trap?
What is the opposite of a liquidity trap?
The idea that an economy could be caught in a liquidity trap was popularized by New York Times columnist and economist Paul Krugman in the aftermath of the financial crisis, but the concept goes back at least as far as John Maynard Keynes. The basic idea is that there are times in when consumers, businesses, and investors are determined to conserve cash rather than spend or invest it even when interest rates are low. After Lehman Brothers collapsed, there was a lot of talk about investors simply wanting a “return of assets” rather than a “return on assets.”
Falling into a liquidity trap complicates economic policymaking. The central bank can cut interest rates, but that will do little to stimulate growth. It may even prompt more precautionary saving on the part of households and businesses because the rate cuts sends the message that the economy is in serious trouble.
This is often combined with the idea of a “balance sheet recession,” which occurs when businesses and households seek to repair their balance sheets by reducing debt and increasing cash. In a balance sheet recession, even interest rates near zero will not prompt businesses to expand through borrowing because they are focused on lowering their leverage. The same applies to households: cut interest rates as much as you want, in a balance sheet recession, people just do not feel comfortable borrowing to spend more.
The Keynesian response to liquidity traps and balance sheet recessions is fiscal expansion. If the private sector will not borrow to spend and invest more, the government can act as a sort of borrower of last resort. By spending more than it collects in revenue at a time when the households and businesses are trying to do the opposite, the government can act to essentially fill in the “spending gap” that is dragging down growth.
Can the Government Really Spend Its Way Out?
At least, that’s the theory. One obvious problem with that solution is that the same concerns that make people seek out austerity for their businesses and households also encourage a politics of austerity. Investors want to own businesses with solid balance sheets, households want to build up their nest eggs, and voters want politicians who are fiscally responsible. The trouble, of course, is that because everyone’s income comes from someone else’s spending, a collective decision to cut back on spending by households, governments, and businesses means that incomes have to fall as well.
The other problem is that additional government spending may prompt households and businesses to engage in even more precautionary savings. Perhaps the deficit spending just sends a signal that bad times are upon us so it’s time to tighten our belts. Perhaps people worry that today’s debt will need to be paid back with more taxes tomorrow; so they start saving up to afford the tax burden. Just like accommodative monetary policy might prompt economically restrictive behavior by households and businesses, expansionary fiscal policy can trigger financial tightening.
The Unstoppable American Consumer
Over the decades, a lot of ink has been spilled across economic journals and pixels shed on the financial corners of the internet over the issues around liquidity traps and the effectiveness or possibility of fiscal and monetary responses. We can safely leave those aside for now because that isn’t our problem. We do not have a conventional liquidity trap. We have something like the opposite.
The Federal Reserve has raised the federal funds rate by 525 basis points since last March. This is a record-setting pace for monetary tightening. As Fed Chairman Jerome Powell said in his recent keynote speech in Jackson Hole, typically this would mean that the stance of monetary policy had become restrictive. Yet economic growth has been accelerating this year, defying the predictions that we would enter a recession.
Consumer spending rose 0.8 percent in July in nominal terms. After adjusting for inflation, consumer spending climbed 0.6 percent. The Atlanta Fed’s real-time reading of gross domestic product shows us growing at a 5.6 percent real rate. While that number is likely to come down, it’s not likely to fall to anything that will look like an economy being “held back” by a “restrictive” monetary policy.
Neil Dutta, who heads up U.S. economic research at Renaissance Macro Research, has been one of the few economists who correctly saw that employment and consumer spending would keep the economy out of a recession this year. On Monday, he said that the economy is growing around six percent in nominal terms.
“We have an unsustainably strong economy, still,” Dutta told Bloomberg’s Surveillance program.
When you are in a liquidity trap, easing monetary policy cannot get people to spend and invest more. Now, we’re discovering the tightening monetary policy is failing to get people to spend and invest less. The economic tide keeps rising even though the Fed has declared it is time for an ebb.
One serious question is whether this is happening because of a series of economic situations in which monetary policy was rendered ineffective—first a liquidity trap and then a liquidity tide—or whether monetary policy itself is doomed to be less effective than many economists thought. Perhaps it always has been so. Or perhaps we’ve just entered a post-monetary era.