Avoiding a Liquidity Trap

Wednesday, 17 Dec 2008 04:33 PM

By Ralph Hostetter

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The Federal Reserve Bank, in another effort to stimulate the nation's economy, reduced its target for overnight interest rates to between zero and 0.25 percent, the lowest level on record.

Reductions in fed rates are then reflected in lower bank rates across the nation, for the most part.

As expected, the stock markets reacted substantially to the upside. Dow Jones was up by nearly 360 points.

That's the good news.

Waiting in the wings may be less good news.

Zero interest rates, while sounding great, invariably carry very dangerous, unintended consequences, one of which is a condition known as a liquidity trap.

The classic definition of a liquidity trap is a condition that occurs when the nominal interest rate is close to or equal to zero.

At the zero point, the monetary authority, in this case the Federal Reserve, finds itself unable to stimulate the economy.

Normally, the Federal Reserve can stimulate the economy by lowering interest rates or increasing the monetary base. These actions in turn increase borrowing and lending, spending and investing.

However, with interest rates at near zero, the Federal Reserve cannot lower rates to stimulate the economy.

The Federal Reserve is left with one choice, and that is to print more money. The money must now find its way into the economy. Traditionally, this course is through the banking system. However, in a liquidity trap environment with banks unwilling to lend — as in the case of Japan, where the new money went into bank reserves — the newly created liquidity is trapped behind unwilling bank lenders, thus forming the liquidity trap.

Traditionally, the Federal Reserve Bank uses the Fed rate as one of its monetary tools to stimulate and influence conditions involving the flow of currency.

Reductions in the Fed rate have traditionally created a flow of cash to provide liquidity as banks with cash surpluses make available money for other banks to borrow to improve their balance sheets.

These transactions have virtually disappeared as lending banks became more aware of problems that may exist on the balance sheets of borrowing banks. The lending banks are hoarding their cash rather than take risks.

Interest rate reductions in Japan faced a similar situation in the late 1990s. Japan kept reducing interest rates until the rate was set at zero in 2001. While holding the interest rate at zero, the Japan Central Bank flooded the nation's banking system with extra cash over the next five years, to 2006.

The additional money failed in its mission. Instead of using the funds to lend money to the economy, the commercial banks used the money to expand their reserves at the Central Bank, some by nine times over the next four years.

With the economy entering an uncertain period, other potential problems are arising.

Property values are declining.

The Labor Department reported consumer prices dropped 1.7 percent in November, the largest one-month decline in 61 years — since February 1947, and according to the Commerce Department, new home construction was down by 18.9 percent in November, the biggest drop since March of 1984.

Consumer spending is down, particularly in big ticket items such as automobiles, appliances, and electronics.

Unemployment has reached 6.7 percent. Job losses added up to 533,000 in November alone.

The risk of deflation has appeared.

None of these warning signs has escaped the attention of the chairman of the board of governors of the Federal Reserve, Ben Bernanke. One could say the present situation is his “cup of tea.”

Described as a student of the Great Depression of the 1930s, as well as of Japan’s lost decade, he is aware of the risks and rewards presented by zero interest rates and the resulting liquidity trap.

In a paper delivered in 1999, then-professor Bernanke offered a remedy to the government of Japan, advancing the theory that a “more expansionary monetary policy was needed.”

Under what is known as “a policy of quantitative easing,” the banking system of Japan was flooded with money with the aim of easing pressure on banks, persuading them to start lending again and stop a downward spiral in prices.

Since mid-September, as chairman of the Fed, Bernanke has been following his own advice here in the United States. He has ordered the printing of billions and billions of dollars and has pumped them into the financial system of the country.

The nation awaits the results of Chairman Ben Bernanke’s bold attack on the recession.

E. Ralph Hostetter, a prominent businessman and agricultural publisher, also is a national and local award-winning columnist. He welcomes comments by e-mail sent to eralphhostetter@yahoo.com.

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