Seven Myths. Nay, Seven Follies (IV)4607
Of traps and mice.
4. We are in a liquidity trap.
From a conceptual point of view this is the argument most often invoked by "economists" arguing in favor of gigantic fiscal expenditure plans. Krugman was preaching the liquidity trap during the 1990s, and he was talking about Japan. We have already seen how useful public expenditure was there. He has not changed his mind, which is, again, not a surprise to anyone.
The argument is: "people" are so eager to hold liquid assets (currency) that it would take a hugely negative nominal rate to convince them to purchase real assets, i.e. to invest. Said it in reverse: expected nominal rates of returns on investments are so low that investors are willing to borrow if and only if lenders charge them negative interest rates, i.e. only if lenders pay an interest to their borrowers. Because this is an impossibility (borrowers will then borrow an infinite amount), we are in a liquidity trap. People hold cash and do not invest, everyone goes unemployed.
Notice that, in order for the argument to have any bite (not the bite PK&Co argue it has, but just any bite) it requires believing that it is monetary policy that, by lowering the nominal rate, induces people to take on productive investments. If you believe, as I do, that monetary policy is scarcely, if at all, effective as a tool to generate growth when economies are not growing, then the whole debate becomes irrelevant. In other words, for the liquidity trap argument to be even worth pursuing we need to believe that monetary policy matters big time. No matter, let's continue.
The key point is the following: "trap theorists" argue that we observe households not consuming or purchasing any real asset because they like to keep too large a share of their income in cash. Literally: cash under the mattress, because a bank deposit is income invested - banks around here offers positive interest rates on deposit; banks in Europe offer very high nominal rates (4% to 7%) for deposits lasting more than 3 months - so it cannot create a "trap", at least not in the sense they need it (see below).
Now: how much evidence we have of this behavior? Not statistical, just anecdotical evidence. I have none. I have not heard of households withdrawing cash from banks deposits and keeping it at home. Instead, everywhere, we hear of people complaining because they cannot borrow to finance their expenditure in durable goods or what not. We hear of firms that are not receiving credit or are receiving credit only at very high nominal interest rates. Certainly, people are purchasing more liquid assets (T-bills, CDs, and so on) and fewer illiquid ones (shares and corporate bonds) than two years ago. The reason for this, apparently, is that people expect negative rates of returns from investing in the shares and corporate bonds. Are they wrong or are they right? Trap theorists need to assume people are dead wrong: there's money to be made in many of the investment projects that are not being financed, but households are missing those opportunities and sitting on cash.
The issue, then, is: what may change people expectations about rates of return on illiquid investments? Are people "wrong"? As a matter of logic, we cannot rule this out. But the burden of the proof is on trap-theorists. They need to convince us that:
1) We are on a sunspot. This whole thing is a sunspot, due to private sector's expectations coordinating suddenly in the wrong direction. Actual returns from investments are good, we just do not understand it. Hence we do not invest. We sit on piles of cash and rather starve than take the good opportunities firms are offering us. I have no strong evidence to reject this statement, what do I know? Still, do PK&Co have any evidence supporting their statement? Not that I know.
2) Assuming 1) is correct, public spending, massive public spending, is the correct tool to make everyone optimistic again. We need to be convinced of this. In other words, not only you need to convince me this is just a sunspot, you need to convince me that I will abandon this sunspot and go back thinking straight again (were we thinking straight in 2006, at the peak of the bubble?) only if the Federal Government decides to make central Montana and Southern Idaho wireless, or to build more schools in Milwaukee, or give more money to Medicare for the elderly to purchase Viagra. Well, the last one is not so bad: it may indeed produce a few more smiling people in the public parks, which is uplifting. In any case, this must be proved. Assuming 1) is correct, my hunch is that President Obama's speeches have a bigger chance of lifting the American Spirit than wirelessing North Dakota does. But, then, I may be wrong: I have worked only briefly on sunspots ...
This is the logic behind the liquidity trap story and the claim that only a couple of trillions of public spending will get us out of it. It is not incoherent, it is just not credible. Those are two different things, indeed. It's an expectations-based story (as they have finally figured out even in the anointed circles: my colleague Costas Azariadis had been claiming it since early 2007...), a story we understand very well in THEORY. Now, where's is the EVIDENCE? Not only: where is the EVIDENCE EXPECTATIONS WORK LIKE THAT?
While we wait for the evidence, let me try a brief and simple alternative explanation of the same facts.
There is no liquidity trap, there is a "precautionary bank reserves trap", and this cannot possibly be cured with more public spending and public debt. Households are hoarding nothing, households are saving as much as they can because they are deeply in debt (some of them, not all, but enough of them are), their assets are clearly worth less than before and their expected incomes are not growing anymore. Saving to pay debt is the same as investing, hence household are investing by giving money back to the lender, when they can, and defaulting, when they cannot. No liquidity trap here.
Banks are making losses when households default on debts, and are receiving cash when households pay back debt or make a deposit. Banks are also receiving an enormous amount of cheap reserves from the Fed and they react by hoarding cash and excess reserves with the Fed. Why are they doing so? They are doing so to avoid going bankrupt. Not only they are desperately afraid of the mounting losses on some of the loans households cannot pay; they are even more afraid of the time bombs called generically "derivatives" they are still sitting upon. It is that fear that paralizes them. They are afraid of the consequences of their careless choices of the last ten years; choices that, they claimed, were profitable and from which they extracted "profits" (biiiig profits) and bonuses (even biiiiiggger bonuses). Those profits did not exist, and all that money should have remained in the banks, as capital reserves, to avoid insolvency now.
Note, it is not the shareholders of banks that are paralized, those are already dead and economically irrelevant as they almost lost all their capital (Citibank was worth less than Unicredit today, and Unicredit was worth 1/8 of its old value yesterday!). The managers of the banks are frozen: they lost the shareholders' money and do not like the idea of losing the empires they are sitting upon. It is a nice job to be the bosses of Citi, Bank of America and so on. It makes you a master of the universe, indeed. Why giving it up voluntarily if you do not have to?
So that's the trap, and it is not a liquidity trap. It is a "banking trap" or a "principal-agent trap": it has to do with the banks, their solvency or lack of it thereof, their misterious portfolios, and the desire of banks' managers to keep their nice and well paid jobs. The same thing, exactly the same thing, happened in Japan after 1993/94, so there is nothing new here, really. Will gigantic public spending change ANYTHING along these dimensions? I very much doubt it. Certainly, there is neither theory nor empirical support for such a claim. Right now, the best strategy for bank managers is to pile up reserves (they even pay like T-bills), plead for a bailout, and not lend unless the investment is super safe. In fact, to the extent that four or five very big players have a decisive impact on the US interbank market, "lending little" is clearly a dominant strategy. And little they lend, we are told.
Hence we, the mice, are certainly in the(ir) trap. I am not sure it is liquid, though ...