a move that none other than Milton Friedman condemned as helping to strangle economic recovery

TO BE NOTED: From the NY Times:

"Stay the Course

By PAUL KRUGMAN

The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, it’s déjà vu all over again — literally.

For this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts, the conventional way to perk up the economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession.

Yet such unconventional measures make the conventionally minded uncomfortable, and they keep pushing for a return to normalcy. In previous liquidity-trap episodes, policy makers gave in to these pressures far too soon, plunging the economy back into crisis. And if the critics have their way, we’ll do the same thing this time.

The first example of policy in a liquidity trap comes from the 1930s. The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while F.D.R. tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

The second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery, with the economy growing almost 3 percent in 1996. Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.

And here we go again.

On one side, the inflation worriers are harassing the Fed. The latest example: Arthur Laffer, he of the curve, warns that the Fed’s policies will cause devastating inflation. He recommends, among other things, possibly raising banks’ reserve requirements, which happens to be exactly what the Fed did in 1936 and 1937 — a move that none other than Milton Friedman condemned as helping to strangle economic recovery.

Meanwhile, there are demands from several directions that President Obama’s fiscal stimulus plan be canceled.

Some, especially in Europe, argue that stimulus isn’t needed, because the economy is already turning around.

Others claim that government borrowing is driving up interest rates, and that this will derail recovery.

And Republicans, providing a bit of comic relief, are saying that the stimulus has failed, because the enabling legislation was passed four months ago — wow, four whole months! — yet unemployment is still rising. This suggests an interesting comparison with the economic record of Ronald Reagan, whose 1981 tax cut was followed by no less than 16 months of rising unemployment.

O.K., time for some reality checks.

First of all, while stock markets have been celebrating the economy’s “green shoots,” the fact is that unemployment is very high and still rising. That is, we’re not even experiencing the kind of growth that led to the big mistakes of 1937 and 1997. It’s way too soon to declare victory.

What about the claim that the Fed is risking inflation? It isn’t. Mr. Laffer seems panicked by a rapid rise in the monetary base, the sum of currency in circulation and the reserves of banks. But a rising monetary base isn’t inflationary when you’re in a liquidity trap. America’s monetary base doubled between 1929 and 1939; prices fell 19 percent. Japan’s monetary base rose 85 percent between 1997 and 2003; deflation continued apace.

Well then, what about all that government borrowing? All it’s doing is offsetting a plunge in private borrowing — total borrowing is down, not up. Indeed, if the government weren’t running a big deficit right now, the economy would probably be well on its way to a full-fledged depression.

Oh, and investors’ growing confidence that we’ll manage to avoid a full-fledged depression — not the pressure of government borrowing — explains the recent rise in long-term interest rates. These rates, by the way, are still low by historical standards. They’re just not as low as they were at the peak of the panic, earlier this year.

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

Those demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss."

also good for us: a weaker dollar will help our exports, at Europe’s expense

From the NY Times:

---

May 15, 2009, 7:48 pm

China and the liquidity trap

I liked this David Leonhardt article about the China-US economic relationship. But I do have a problem with this passage:

The most obviously worrisome part of the situation today is that the Chinese could decide that they no longer want to buy Treasury bonds. The U.S. government’s recent spending for bank bailouts and stimulus may be necessary to get the economy moving again, but it also raises the specter of eventual inflation, which would damage the value of Treasuries. If the Chinese are unnerved by this, they could instead use their cash to buy the bonds of other countries, which would cause interest rates here to jump, prolonging the recession.

Um, no. Right now we’re in a liquidity trap, which, as I explained in an earlier post, means that we have an incipient excess supply of savings even at a zero interest rate. (By the way, I’ve had a chance to see the transcript of the PEN/ NY Review event, and I don’t think I was misrepresenting Niall Ferguson’s position.)

In this situation, America has too large a supply of desired savings. If the Chinese spend more and save less, that’s a good thing from our point of view. To put it another way, we’re facing a global paradox of thrift, and everyone wishes everyone else would save less.

Or to put it a third way, the argument that a reduction in China’s dollar purchases would be contractionary for America because it would drive up interest rates is equivalent to the argument that fiscal expansion is contractionary for the same reason — and equivalently wrong.

But what if China doesn’t spend more, but just reallocates its reserves from dollars to, say, euros? The answer is, that’s also good for us: a weaker dollar will help our exports, at Europe’s expense.

One of the things I tried to tell the Chinese was precisely that the old co-dependence no longer exists. For now, at least, their dollar purchases are an unalloyed bad thing from America’s point of view."

Me:

If China were buying lots of US bonds, and then stopped, couldn’t that have an effect on the demand for bonds and hence interest rates if the slack isn’t taken up by other investors? Let’s say that this view was taken as a sign that the US is no longer safe in the view of the Chinese, and other investors thought that as well? Couldn’t they choose to buy bonds elsewhere, thereby causing us to raise our rates? To the extent that somebody has to buy something, how can the demand and price for it not matter? I don’t see the analogy with crowding out in the stimulus. I’m saying that a large part of the reason that investors are buying our bonds is their perceived safety. If that were to deteriorate, how could it not cause a problem for our bonds? — Don the libertarian Democrat

"Toyota was receiving subsidies worth $300m to build its Mississippi plant"

Another Helicopter post. From Richard Adams in the Guardian:

"The worst piece of economic news coming out of the US in the last week wasn't yesterday's move by the Federal Reserve to cut its fed funds interest rate to a Depression-era floor of zero. True, the fact that official interest rates are hovering around 0% is eye-catching, but the move was more symbolism than anything else – since some US Treasuries are already being traded at close to zero interest. In other words, the Fed's cut was merely a reflection of reality.

(And in case anyone in the UK or Europe was feeling smug about this event, don't worry – the Bank of England and the European Central Bank will be joining the "zero club" soon enough in 2009.) ( TRUE )

And no, the worst piece of economic news wasn't even the more significant discovery that US consumer prices fell by 1.7% last month, given that it raises the spectre of deflation, a dangerous spiral of falling prices and consumers sitting on their hands, asking why they should buy now when things will be cheaper next month? ( WON'T HAPPEN )

No, potentially the worst piece of news passed by almost without notice: the decision by the Japanese carmaker Toyota to hit the brakes on its construction of a new factory in Mississippi. That decision wrapped up the past and future prospects for the US into one unhappy package. If Toyota cancels its plant, the US economy won't collapse, of course. But it is more than just a bad omen. It's a warning of what is to come for the Federal Reserve and the incoming Obama administration.

Toyota's new car plant wasn't just any assembly line. It was to be the first US factory to make the famous Prius hybrid. Toyota had already invested $300m in it – but it may prefer to kiss that money goodbye than commit the extra $1bn needed to open it. That's a vote of no-confidence in the US economy for starters. More importantly, the Prius was to the 2000s economic bubble what the Aeron chair was to the dotcom boom. For the last couple of years it has been impossible to buy a new Prius off a dealer's lot – the waiting list was too long. Then the sharp spike in the price of oil this year gave another reason to buy the fuel-efficient Prius. Hence Toyota's decision to build a plant in Mississippi. ( MIGHT IT HAVE SOMETHING TO DO WITH THE FALLING PRICE OF OIL, AND THE STRENGTH OF THE YEN? )

But let's not forget that the major economic story of the last couple of weeks – before Bernard Madoff made the front pages – was the begging by Detroit's Big Three carmakers for a government bail-out.

Opponents of the bail-out made much of Detroit's inability to compete with the Japanese manufacturers such as Toyota (a situation largely the result of Congress's decision to restrict car imports from Japan in the 1980s, but that's another matter)( BUT A GOOD POINT. IT LET THE US AUTOMAKERS FEEL FREE NOT TO INNOVATE ), arguing that this would be throwing good money after bad. Most Republicans opposed giving the money to General Motors and Chrysler, including those southern senators who boasted a thriving car industry based on new foreign car factories built in their states. ( PURE POLITICS )

Among the Republicans who shot down the bail-out were Roger Wicker and Thad Cochran, the senators from the great state of Mississippi. But here's the question that could haunt them and their constituents: if the Detroit bail-out had passed, Toyota would have been less likely to have put its Prius factory on ice, and the 2,000 jobs that were to come with it. (Toyota has a choice that GM doesn't have. The Japanese firm can scrap its plans for Mississippi and ship in cars from Japan instead. But that doesn't bring any jobs to Tupelo.)

After all, it's not just sales at Ford and GM that are suffering: in November 2007 Toyota sold more than 16,000 Prius models. Last month it sold just 8,000. The problems of the auto industry are long-term – over-capacity, in the main – but with a short-term kicker: car sales are intimately connected to personal borrowing, since most Americans rely on loans to buy a car (especially new ones). Since the credit crunch has trickled down from Wall Street, it has become harder to get credit to buy a car, since lenders are now more cautious. On top of that, the state of the economy is such that people are delaying a big purchase like a car (or a house) if their income is being squeezed and they decide to pay off earlier debts ( TRUE. I POSTED ABOUT THIS EARLIER ). Even cutting prices may not work ( TRUE, BUT IT WOULD HELP ). The dreaded deflation effects mentioned above may make matters worse. ( INDUBITABLY )

Toyota won't be the only foreign investor changing its plans in the face of a recession. Rebuilding US balance sheets, both commercial and personal, is going to take some time, as businesses and consumers untangle themselves from debt. That task will be made longer and harder if the dinosaurs of Detroit collapse, whether they deserve to or not, or if a new wave of manufacturers such as Toyota are scared away by the toxicity of the economy. (Toyota was receiving subsidies worth $300m to build its Mississippi plant,( FANCY THAT.FREE MARKETS YOU SAY ) in case anyone thinks only Detroit has carmakers who want government funds to help them.)

The woes of Toyota and Mississippi, GM and Detroit, and the fed funds rate hitting zero are all connected. The US economy – along with much of the rest of the so-called developed world – has entered what economists call a "liquidity trap", where holding cash (which earns 0% interest, but is entirely safe) is as good an investment as any other low-risk asset. At that point, central banks may as well just print money to re-inflate their economies – as the FT's Martin Wolf ( DOES EVERYBODY READ WOLF? ) remarked: "As Robert Mugabe has shown, anybody can run a printing press successfully."( I BLOGGED ABOUT THIS POST ) (Certainly, deflation isn't a problem in Zimbabwe.) In that case, why not bail-out Detroit and offer zero-interest loans to the likes of Toyota as well? After all, building eco-friendly, greener cars such as the Prius was part of the Obama economic platform. ( THEY MIGHT WELL DO IT )

The longer-term problems will remain, such as cleaning out the Augean stables( CALL HERAKLES ) of bank balance sheets – and the time has surely come for more radical action in that regard. But in the short term, there's no point in building a new factory if no one is buying cars ( SHARP ).

Milton Friedman once wrote about using helicopters to drop cash on a population and provoke price rises. Time to polish up the rotors and rev the engines. ( IT'S A LOVELY SOUND )

"As I put it, perhaps too glibly, the central bank needed to “credibly promise to be irresponsible.”

Paul Krugman claims to have founded the Helicopter Club:

" A whiff of inflationary grapeshot

Greg Mankiw suggests that the Fed respond to the crisis by committing to substantial inflation over the next decade. Great idea, wish I’d thought of it. Oh, wait …

Actually, Greg has arrived at the same conclusion I did more than a decade ago, when I tried to model the problems then facing Japan, and now facing us. As I pointed out back then, the essence of a liquidity trap is that the real interest rate is too high, even when the nominal rate is zero. So the theoretically “correct” answer, if you can swing it, is to create expected inflation, pushing the real rate down.

As I put it, perhaps too glibly, the central bank needed to “credibly promise to be irresponsible.”

The thing is, at the time my analysis was widely treated as somehow wild and crazy, even though it came straight out of an extremely buttoned-down theoretical model. Japan was supposed to suffer for its sins, not inflate its way out of them. I wonder if similar proposals for the United States will receive the same reception.

Update: I should add that my initial paper led to a fairly extensive literature on the subject of creating inflationary expectations. See, for example, the references here."

What about Helicopter Money?

"we must instead allow it to be destroyed, to be liquidated in as orderly a fashion as possible, as quickly as possible."

There are lots of people who don't like what I'm calling for. Sudden Debt is one:

"The latest 3-month US Treasury bill auction resulted in 0% rate and was oversubscribed four times. How about that, for deflation and risk aversion, eh?

I am not surprised. This is the hangover following the wild easy-credit party that ultimately saw financial engineering elevated to the same position as real engineering (yes, I was offended). The same party that created the awesome stupidity of $65 trillion in credit default swaps which first allowed piling on much more debt than prudent, and which are now inhibiting the cathartic process of its quick demise.

What's next? Will free money (for the federal government, anyway) result in another Greenspanite bubble? No, no time soon. This development is not something that the government wants, you understand. It clearly underscores the fact that deflation is happening as we speak, that assets carrying even the smallest amount of risk are shunned in favor of mere capital preservation. The debt trap has become - predictably - a deflationary liquidity trap, American economists' and policy makers' greatest phantom menace since 1929.

I will, thus, say it once more: instead of allowing this deleterious process to drag out for years by attempting to preserve debt (as the Fed and Treasury are doing now), we must instead allow it to be destroyed, to be liquidated in as orderly a fashion as possible, as quickly as possible."

I'm certainly for decreasing our debt, but I'm not sure what's being called for. Selling government assets? Increasing taxes? Cutting expenses?

I'll only say that the whole point of my plan is to ultimately reduce the debt and deficit. It is paradoxical that the only way to do that is to temporarily increase our debt, but such is the world.

"While I recognise the theoretical possibility that there could be something to the ‘keeping (some of) your power dry’ argument"

Willem Buiter posts again on the Liquidity Trap problem:

"The (formerly) advanced industrial countries are all in or headed for the liquidity trap ‘lite’. This is the situation where the short-term risk-free nominal interest rate cannot fall any further. A ‘heavy’ or ‘deep’ liquidity trap occurs when nominal risk-free rates at all maturities are at their lower bound(s).

A liquidity trap ‘lite’ may occur even when short-term rates above zero. It will certainly occur when the short-term nominal interest rate falls to zero. Unless the monetary authorities are willing and able to tax currency holdings, the zero nominal interest rate rate on bank notes sets a floor for all short-term nominal interest rates. I have not seen too many central bankers perusing the works of Silvio Gesell, so for the time being, I will treat a zero short risk-free nominal interest rate as the effective floor for the risk-free nominal interest rate.

If zero is the floor, there is no reason not to go there immediately. The recession in the US, the UK, the Eurozone, Japan and the rest of Europe is, with probability verging on certainty, going to be so deep and so prolonged, that the zero lower bound will be reached even by the most anal-retentive gradualist central bank before the middle of 2009. So why not get it over with in December 2008 and possibly do some good in the mean time? The required cuts in the official policy rate would be trivial in Japan (30 basis points) and in the US (100 basis points - assuming the 35 basis points penalty on bank reserves is abolished). For the UK, a mere 300 basis points cut and for the Euro Area a 325 basis points cut would anchor the official policy rate at the floor (again assuming the 25, respectively 50, basis points reserve penalties of the Bank of England and the ECB are eliminated).

In all likelihood, cutting the central banks’ official policy rates to zero will not provide a major stimulus to financial intermediation and this to aggregate demand. But even if it doesn’t help, it certainly won’t hurt.

Dr. Lorenzo Bini Smaghi, Executive Board member of the ECB disagrees. He wants to keep some of the ECB’s interest rate powder dry. He obviously has watched “They died with their boots on”, or some other movie of the battle of Little Big Horn in which George Armstrong Custer and his command were outgunned by the Cheyenne, the Lakota and the Arapaho.

The analogy with not firing your last bullet except in extremis is, however, not convincing. A cut in interest rates does not exhaust its effect on economic activity as soon as the cut is implemented. A short-term, temporary cut has a smaller effect than a long-term, more permanent cut. Cutting earlier means that the cumulative effect on activity at any given future date is likely to be larger. In George Armstrong Custer terms, once you pull the trigger, the gun keeps in firing.

It is possible that there are complex psychological mechanisms (of the kind most economists and central bankers don’t understand) that may cause an interest rate cut of a given magnitude to produce a greater cumulative effect if it is administered at just the right moment - say when an inflationary or deflationary bubble is most likely to be punctured or when fears, phobias and bandwagon effects can be influenced by some highly visible, even if largely symbolic, policy action.

While I recognise the theoretical possibility that there could be something to the ‘keeping (some of) your power dry’ argument, I have never seen any empirical evidence that supports it, or a rigorous analytical model that lays out the precise mechanism. The argument should therefore be dismissed as a constraint on actual planned rate cuts."

Here's my comment:

I’ve often wondered if the public officials who use phrases like “keep your powder dry”,speak like this at home, or whether it’s an affliction that one gets when taking on an air of pomposity in public life.

“Are you coming to bed dear?”

“Not tonight love. I need to keep my powder dry. Sorry.”

Maybe it has something to do with the way they speak, but I’m having a hard time taking bankers seriously. Sec. Paulson, for example, has forever tainted the word “deploy” for me. Now, when I hear the word “stigma”, I immediately assume that it has something to do with banking, although I’m not quite sure what.

I’m sorry. I apologize to everyone for posting. I’d liked to say more, but, well, I’m unfortunately out of powder.

Sadly, I don’t think Mr. Buiter’s advice will be taken.

Posted by: Don the libertarian Democrat | December 2nd, 2008 at 3:14 am |

"figures that suggest the need for a fiscal stimulus that’s enormous by historical standards": Were We In Our Old Universe

Paul Krugman on a Liquidity Trap:

"It’s a curious thing that even now, when we are clearly in a liquidity trap, we still have a lot of economists denying that such a thing is possible. The argument seems to go like this: creating inflation is easy — birds do it, bees do it, Zimbabwe does it. So it can’t really be a problem for competent countries like Japan or the United States.

This misses a key point that I and others tried to make for Japan in the 90s and are trying to make again now: creating inflation is easy if you’re an irresponsible country. It may not be easy at all if you aren’t."

One could ask the same question about the deficit and debt, but why bother?

"And once you realize that central banks may not be able to move expectations about future money supplies, it becomes a real possibility that the economy will be in a liquidity trap: if interest rates are near zero, money printed now just gets hoarded, and monetary policy has no traction on the real economy."

That's Japan. They're population is different than ours in their expectations and investing decisions, so that it's not obviously an apt comparison. For example, oddly, average Japanese investors are buying stocks now, while ours are shell-shocked.

"Back in 1998 I argued that the Bank of Japan needed to find a way to “credibly promise to be irresponsible.” That didn’t go down too well, but it was what sober, careful economic analysis prescribed.

Or as I said in the linked paper,

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem. "

This sounds suspiciously like a policy of an elite fooling an ignorant public. Can't bother them with the truth. Isn't this the Paradox Of Thrift under a different guise? The answer is incentives.

"OK, so now back to Hatzius et al. They emphasize the role of the disruption of credit markets in pushing us into a liquidity trap. They then turn to an estimate of likely changes in the “private sector balance” — the difference between private sector saving and private sector investment. And it’s stunning:

The GS house price forecast combined with current equity prices and credit spreads implies a rise in the private sector balance from +1% of GDP in the second quarter of 2008 to +10% in the fourth quarter of 2009— - a rise of 9 percentage points, or 6 points at an annual rate.

What’s the answer? Huge fiscal stimulus, to fill the hole. More aggressive GSE lending. Maybe a “pre-commitment” by the Fed to keep rates low for an extended period — that’s a more genteel version of my “credibly promise to be irresponsible.” And maybe large-scale purchases of risky assets.

The main thing to realize is that for the time being we really are in an alternative universe, in which nothing would be more dangerous than an attempt by policy makers to play it safe."

Memo to Paul: We're still stuck here in the same old dustbin of a universe. This is a version of the Kitchen Sink Argument. If we are in a Lewis Carroll universe, mightn't the rules in it include printing money like it doesn't matter? And how would you judge that any more or less logical than an enormous stimulus and increase in the debt?

Funny thing about a Looking Glass Universe. It's devilishly hard to reason in.

"the Federal Reserve can prevent it, should prevent it, and will prevent it."

James Hamilton on Econbrowser weighs in on deflation risk:

"In a general deflation, the purchasing power of a dollar bill goes higher and higher, and as Greg notes, this can produce big economic problems, as it did for the U.S. in the 1930s or Japan in the 1990s. But it is absolutely a problem that the Federal Reserve can fix. If you increase the quantity of dollar bills fast enough, you're sure to create inflation, not deflation. And the Federal Reserve has unlimited power to increase the quantity of dollar bills.

Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.

To which I say, pshaw! "

The Fed could:
1) Buy debt of the Treasury by creating new dollars to pay for it
2) But all commercial paper the same way
3) Ditto Tokyo Stock Exchange
4) Ditto anything else

The net effect would be inflation, but deflation would be gone.

I agree, and made the same point in an earlier post. Here was the conclusion:

"As long as governments print money and run deficits, you cannot have deflation," Lerrick said."

So, in the end, doesn't that mean inflation is the only real problem?

Here's Hamilton answering a question:

"I'm claiming that prolongued deflation cannot be a reasonable forecast for the United States, because the Federal Reserve can prevent it, should prevent it, and will prevent it.

Posted by: JDH at October 29, 2008 08:47 AM"

From my perspective, this seems clear.

Liquidity Trap: A Good Explanation

From Mark Sunshine in the NY Times. Please read the whole article:

"The liquidity trap has neutered the Fed and its chairman, Ben Bernanke, because there isn’t much that the Fed can do with money supply or interest rates to make things better (despite reports that the Fed may cut interest rates again soon). Only fiscal stimulus – tax cuts or government spending hikes intended to increase demand — will unplug the system. "