Bloomberg is reporting Bernanke May Run Low on 'Ammunition' for Loans, Rates
Reserve Chairman Ben S. Bernanke may be running out of room to pump
money into the financial markets and cut interest rates to rescue the
economy. The Fed has committed as much as 60 percent of the $709
billion in Treasury securities on its balance sheet to providing
liquidity and opened the door to more with yesterday's decision to
become a lender of last resort for the biggest Wall Street dealers.
using up their ammunition on the liquidity and overnight interest-rate
fronts," said Lou Crandall, chief economist at Jersey City, New
Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's
largest broker for banks and other financial institutions.
the most dire of circumstance, the Fed could go so far as to cut its
benchmark rate to zero, promise to hold it there and flood the
financial system with more than enough money to ensure that happened,
under a strategy known as "quantitative easing."
sounds suspiciously like the liquidity trap scenario. The "trap"
develops when the central bank simply cannot force additional credit
down the throats of prospective borrowers.
And with a tip of the hat to Calculated Risk
please consider Paul Krugman's article How close are we to a liquidity trap?
one way to think about the liquidity trap — a situation in which
conventional monetary policy loses all traction. When short-term
interest rates are close to zero, open-market operations in which the
central bank prints money and buys government debt don’t do anything,
because you’re just swapping one more or less zero-interest rate asset
Milton Friedman On Liquidity Traps
Right now we’re in a situation in which Treasury
bills yield considerably less than the Fed funds rate; to at least some
extent this may reflect banks’ nervousness about lending to each other,
even in the overnight market. And to the extent that’s true, Treasuries
— not Fed funds — are the interest rates to look at.
As of 10:38 this morning, the one-month Treasury rate was 0.57; the three-month rate was 0.825. Are we there yet? Pretty close.
the current setup is essentially the liquidity trap that Japan fell
into. Wikipedia has this (and much more) to say about Liquidity Traps
monetary economics, a liquidity trap occurs when the economy is
stagnant, the nominal interest rate is close or equal 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 keep assets
in short-term cash bank accounts or hoards rather than making long-term
investments. This makes the recession even more severe, and can
contribute to deflation.
Friedman Is Wrong
Milton Friedman suggested that a
monetary authority can escape a liquidity trap by bypassing financial
intermediaries to give money directly to consumers or businesses. This
is referred to as a money gift or as helicopter money (this latter
phrase is meant to call forth the image of a central banker hovering in
a helicopter, dropping suitcases full of money to individuals).
economist Paul Krugman suggests that what was needed was a central bank
commitment to steady positive monetary growth, which would encourage
inflationary expectations and lower expected real interest rates, which
would stimulate spending.
Friedman is wrong and Japan proved it. Japan's national debt went from
nowhere to 150% of GDP and they are still battling the aftermath of
deflation for 18 years or more.
Artificially stimulating the economy eventually causes all sorts of problems.
idea of a "liquidity trap" flows from a Keynesian approach to
economic/monetary policy in the belief that there is not enough money
in the system and things would somehow be better if more money could be
forced into the system.
There are major problems with this thinking.
money at the problem simply encourages more overcapacity, weakens the
currency, and causes prices of necessities like oil to rise while not
doing a thing for wages. If dropping money out of helicopters worked,
Zimbabwe would be the greatest economic force on the planet.
the Fed simply does not know the correct amount of money or the correct
interest rate on it either any more than it knows how to set the
correct price of orange juice or TVs. If the Fed did know, the trap
would never have happened in the first place.
Who is to blame?
should be clear from the above that the Fed must take a big share of
the blame for the mess we are in. Ironically, the best case against the
Fed was made in a speech by Fed Governor Richard W. Fisher.
Please consider Confessions of a Data Dependent
Fisher's remarks before the New York Association for Business Economics on November 2, 2006.
good central banker knows how costly imperfect data can be for the
economy. This is especially true of inflation data. In late 2002 and
early 2003, for example, core PCE measurements were indicating
inflation rates that were crossing below the 1 percent "lower
boundary." At the time, the economy was expanding in fits and starts.
Given the incidence of negative shocks during the prior two years, the
Fed was worried about the economy's ability to withstand another one.
Determined to get growth going in this potentially deflationary
environment, the FOMC adopted an easy policy and promised to keep rates
low. A couple of years later, however, after the inflation numbers had
undergone a few revisions, we learned that inflation had actually been
a half point higher than first thought.
Fed Perpetually Chasing Its Own Tail
In retrospect, the real
fed funds rate turned out to be lower than what was deemed appropriate
at the time and was held lower longer that it should have been. In this
case, poor data led to a policy action that amplified speculative
activity in the housing and other markets. Today, as anybody not from
the former planet of Pluto knows, the housing market is undergoing a
substantial correction and inflicting real costs to millions of
homeowners across the country. It is complicating the task of achieving
our monetary objective of creating the conditions for sustainable
anyone ever wondered how or why the Fed kept blowing bigger bubble
after bigger bubble the confession by Fisher above should explain it
all. The Fed was too slow to halt the massive expansion of credit
leading up to the dotcom bust, then overreacted on the way down which
fueled the biggest housing bubble and credit lending bubbles the world
has ever seen.
Clearly the Fed has no real idea where interest rates should be and thus has no business setting them.
The Austrian Approach
the ideal Austrian approach, a self-regulating free market economy
would continually set interest rates and money supply at the correct
levels. The more goods and quality improvements the economy would
produce, the higher the money's purchasing power would become over time.
What To Do About The Liquidity Trap
what to do about the liquidity trap: Nothing. The concept of liquidity
traps is imaginary. Home prices are too high, they need to correct.
There are too many houses and stores so we should not encourage more
building. Savings should be encouraged, not discouraged. Overcapacity
needs to be worked off not fueled. Bankruptcies are part of the
solution not part of the problem.
The real trap is doing
something as opposed to nothing. Quantitative Easing and ZIRP did not
help Japan and they will not help the US either.
bank simply cannot force additional credit down the throats of
prospective borrowers, nor should it try. Attempts to do so will only
prolong the agony while punishing innocent savers, especially those on