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Source link: http://archive.mises.org/10700/does-a-liquidity-trap-pose-a-threat/

Does a Liquidity Trap Pose a Threat?

September 23, 2009 by

In the popular framework of thinking, which originates in the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditures and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

Consequently, a vicious circle sets in: the decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more. FULL ARTICLE

{ 30 comments }

Carlos Novais September 23, 2009 at 7:43 am

We should not minimize the consequences of letting banks fail saying something like – “it would be bad for a while but then… “. In fact, only assuming a terrible disruption are we able to present the fact something is very wrong with the present system when only with dramatic injections is the system able not to collapse. For transition, it would be better to make the case for making gold and silver legal tender.

William P September 23, 2009 at 8:11 am

“At the end of July this year, US banks were sitting on $729 billion of cash against $1.9 billion in July last year.”

What happens when this money starts being lent out? Is there any way to “drain” it from the banking system to reduce the risk of out-of-control inflation? Borrowing a phrase, to my mind the problem necessarily resembles squeezing out too much toothpaste from the tube.

pravin September 23, 2009 at 8:34 am

the eating up of the seed corn can go on as long as the creditors (china etc) are willing to accept the dollar. a currency crisis will occur before hyperinflation can set in

Ernie September 23, 2009 at 8:38 am

Still learning about the Austrian school. Can someone further elaborate on what the author means by:

“The essence of lending is real savings and not money as such. It is real savings that imposes restrictions on banks’ ability to lend. Money is just the medium of exchange, which facilitates real savings.

As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and nonproductive activities. Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than it releases. The excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings.

This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real savings exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.)”

Point me on to another article if you like. Not following what “real savings” is.

pravin September 23, 2009 at 8:44 am

real savings are real goods and services which havent been consumed.these ‘saved’ goods and services,converted into money form means the consumption is forgone and ‘saved’ for the future ,hopefully to be used productively for increased services and goods.

Mike September 23, 2009 at 8:48 am

Ernie,

I’m very new to the discipline as well and am probably not the best qualified to answer you, but it has to do with the fact that money is not wealth. Wealth is actual, tangible stuff. Wealth exists in a barter society; the lack of currency in such a society simply means that wealth is exchanged directly (this is related to the fact, ignored by most people today, that the #1 thing improving the standard of living is the creation of wealth, i.e. production, and not some government program or anything else).

So in this sense, “real savings” would mean holding on to some sort of real, tangible asset. At least that’s how I see it. I’m just not sure what it means to say banks are doing it; I’ve always thought banks are concerned with dealing with the medium of exchange itself, and not real assets.

William P September 23, 2009 at 8:49 am

Ernie-
Real savings refers to the actual goods, rather than money. Loose monetary policy, i.e. inflation, undermines savings because it causes chronic overvaluation of the dollar, when in fact it is in constant decline. What faces erosion is capital accumulation, because reinvestment into business activities lags.

For example: as a business, I require $500 each month to reinvest into my business; this enables my future production. If due to inflation, my $500 investment is only worth $475, $450, $400 etc. in the future, it is clear that although I’ve been saving, in nominal terms, the required amount, I am still not saving what is required for running a sustainable business model.

Furthermore, the erosion in my capital accounts will be visible (most likely) in my increased, albeit illusory, profits. This, and the inherent effects, are the essence of the business cycle.

AJ Witoslawski September 23, 2009 at 9:20 am

I think it’s important for more Austrian school scholars and followers to write about the possibility of a liquidity trap. I strongly believe that there will be another wave of price and monetary deflation in the near future due to a liquidity trap.

I believe there will be a liquidity trap due to increased levels of government interventionism (i.e. tax hikes and pro-union legislation). These government interventions will make it hard for businesses to remain profitable. Lending to businesses will become more high risk as a result, causing banks to reduce lending. A reduction in lending by banks will reduce profitability and a fall in business profitability will lower the value of bank balance sheets. The result will be two-fold: interbank lending will come to a halt and people will lose faith in the banking system. People will cash out of the banking system due to low interest rates and high levels of risk.

Anything the government does to increase the money supply will simply be “pushing on a string,” as bank failures and credit destruction will inevitably outpace monetary creation. The consequent monetary and price deflation will make it impossible for the lending market to clear, as prices in real terms will be unable to fall to a market level.

All of this combined will lead to a major financial crisis which will shake the world. Such a financial crisis will also shake the fiscal stability of the United States. Tax revenues shall fall sharply while expenditures for social programs (welfare, unemployment benefits, and Medicaid) will rise at unprecedented rates.

Ultimately, this is a testament to the power of the market. Under a free market monetary system, any price deflation would spur monetary creation, as falling prices increase the profitability of money production. Any depression would be immediately counterbalanced by market monetary and fiscal stimuli as private suppliers of money would increase production due to price deflation. Central banks, however, are incapable of setting interest rates and producing the proper (market) amount of money, making depressions inevitable.

Harry Valentine September 23, 2009 at 10:04 am

The Government of Ontario is following the warped advice of Keynes in their power industry. The region has excess generating capacity and the government is implementing plans to boost “green energy” by buying solar electric power at many times the power rate paid by consumers. Keynes said for government to spend money when the people did not and Ontario is doing exactly that. The fall-out from “green-tech” malinvestment will remain to be seen.

Stephen Grossman September 23, 2009 at 10:14 am

“[I]t is certain that no manipulations of the banks can provide the
economic system with capital goods. What is needed for a sound
expansion of production is additional capital goods, not money or
fiduciary media. The boom is built on the sands of banknotes and
deposits. It must collapse….If men are not prepared to save more
by cutting down their current consumption, the means for a
substantial expansion of investment are lacking. Those means
cannot be provided by printing banknotes and by credit on the
bank books.”
Mises, _Human Action_

_Human Action_ is better than current reporting in the mainstream news media.

Eric September 23, 2009 at 10:31 am

I have one problem with this article. It was illuminating until it reached this point:

Money serves ONLY as a medium of exchange…Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer…Note that people demand money not to hold it as such but to employ it in exchange.

This is misleading. Rothbard says that the other uses of money, notably, a store of value, are simply corollaries of the one great function, medium of exchange. But he implicitly states that money DOES serve the purpose of a store of value; that it can be stored to be used as a medium of exchange in the future as well as the present. Other commodities, that can be exchanged, don’t necessarily have this property. Eggs and Bread can be exchanged, but they cannot be stored indefinitely.

This ability to store a medium of exchange is what most people think of when they talk about saving. It permits one to postpone consumption (for as long as one likes) – unlike with bread, where non consumption can result in a loss of wealth as it goes stale over time.

So, in order for this article to keep on a logical footing, I believe it needs to address this issue. Once I encountered this non sequitur, I had trouble following the rest of the article. It is the same that I often encounter when reading the works of Keynes as well.

However, the explanation of the liquidity trap itself was quite clear, and it did help me to understand what Keynes himself was saying so that further light on this subject would be possible. I can see that something is surely fishy in Keynes analysis, but this article left me stuck on the above issue of savings.

BRUCE September 23, 2009 at 10:44 am

One thing stands out in all of this discussion about the liquidity trap. The banks are sitting on more than $700 billion dollars. Last year they were sitting on $2 billion dollars. Lending is falling off a cliff despite the fact that banks are sitting on an enormous pile of cash and interest rates are near 0 per cent. The question is why? The answer is obvious. Banks borrow money at 0 per cent. They then sell mortgages to people at 6 per cent. They are guaranteed a 6 per cent profit. On top of that, the mortgages are insured by the government. It’s all risk free for the banks. Try lending to the consumer at 2 per cent (2% mortgages), and see how fast your liquidity trap disappears. The consumer is more than capable of solving your problem. They just aren’t wealthy enough to continue to provide windfall profits to the banks anymore!

danny September 23, 2009 at 11:01 am

Ernie

Two guys on two desert islands. Each needs to build a hut. In order to have time to build the hut, each needs to pre-save certain items.

Guy 1 (call him Ludwig) — saves some fish so he has time to build instead of having to fish, sticks for the hut frame, palm branches for the roof and walls, etc.

Guy 2 (call him Ben) — he is happy, he doesn’t have to save any of this stuff. He happened to bring his printing press with him!

Both start building. Which one has the means by which to finish the job?

The only way to have production tomorrow and advance society is to save — real savings based on previously having produced something, not false savings based on ink.

Multiply this 6 billion-fold, the problem is the same — society cannot advance without investment. In order for there to be any investment, someone must previously had to produce and save some portion of that production.

Brad September 23, 2009 at 11:11 am

Keynes was right when he said that “for some psychological reason” people may tend to hoard (money or anything else). But maybe there are times when pulling back from the edge is what we need to do. It doesn’t mean that there will never be new risks attempted in the future, it just means that a contraction was necessary as too many poor choices were previously made. Getting into the middle of this and trying to Force a way out only lengthens the time when people will willingly take market risks again as they have no way of knowing when the next capricious State decision will come along. And it will tend to continue to reward that which is legitimately being shrunk away from.

Everyone carrying umbrellas when its down pouring is a psychological decision too, but one that has merit. If there is a time when someone goes around with an umbrella otherwise, and others follow, it will only be for a short time until people realize the skies are clear and put theirs away. The State solution would be prohibit umbrellas and Force people out into the rain and tell them that it isn’t raining at all. They will then take credit when it inevitably does stop raining and everyone eventually dries out.

N. Joseph Potts September 23, 2009 at 11:18 am

This article mentions, but still gives insufficient attention to, the TWO-PARTY aspect of what it calls “lending.” For (nominal) lending to occur, someone (else, not the bank) must BORROW. In a free market, the interest rate mediates between these forces, and seeks an equilibrium between the willingness to lend and the desire to borrow.

Maybe interest rates aren’t free to perform this function. The author doesn’t say. Maybe not enough borrowers are applying to borrow. The author mentions a decline in the quality of purposes borrowers might have for using borrowed funds. A better discussion of BOTH sides of what is, after all, a TRANSACTION would illuminate the scene better.

For lack of dualized terminology, the author also verges on conflating nominal lending with what I will call “real lending” (analogous to “real savings” in the article). The arguments touch on considerations that seem to me to call for the distinction not only in saving, but in lending and, of course, in borrowing (see above).

fundamentalist September 23, 2009 at 11:52 am

Lending isn’t completely dead; it’s just lower than it has been in a long time. Some lending is going on and the money is going into the stock market. That’s why the market has rebounded so sharply, faster than any time since the rebound after th 1929 crash.

AJ Witoslawski September 23, 2009 at 12:39 pm

Another thing to take into consideration is the fact that interest rates are being pushed so low by quantitative easing that private institutions might no longer be willing to lend for the level of risk.

For example, if yields for bonds fall to 2% due to quantitative easing, private financial institutions might be unwilling to lend at such low rates. At this point, the Fed would be printing money to lend, whereas those who receive the new money in the long run would simply “stash it under their beds,” if you will.

The result will be a classical Keynesian liquidity trap, which I believe is consistent with Austrian theory. If the Fed becomes hyperactive, it is quite possible that price deflation actually occurs. The Fed would be “pushing on a string.”

pjones September 23, 2009 at 1:13 pm

BRUCE: “Banks borrow money at 0 per cent. They then sell mortgages to people at 6 per cent. They are guaranteed a 6 per cent profit.”

having worked for a bank I can tell you that we certainly did not borrow money at 0%. We paid for deposits at a certain percentage rate and lent at a higher rate. That’s how banks make money (of course, there are advisory fees, etc. too).

Gerry Flaychy September 23, 2009 at 1:14 pm

Excerpts from Frank Shostak on real savings:

1- “Saving as such has nothing to do with money. For example, if John the baker produces ten loaves of bread and consumes two loaves his saving is eight loaves of bread. In other words, the baker’s saving is

his production of bread

minus

the amount of bread that he consumed. “

http://mises.org/daily/1882

2- “For instance, John the baker has produced ten loaves of bread and consumes two loaves. The income in this case is ten loaves of bread,
and his savings are eight loaves. “

http://mises.org/daily/3640

Stephen Grossman September 23, 2009 at 1:52 pm

“Or we may assume that the banks, frightened by their adverse experience in the crisis brought about by credit expansion, are intent upon increasing the reserves held against their liabilities and therefore restrict the amount of circulation credit [credit granted out of the issue of fiduciary media].

Why bother with today’s mainstream news media? Just open any page of Mises’ _Human Action_.

Dick Fox September 23, 2009 at 2:03 pm

There are two interest rates. There is the interest rate that the FED targets that banks charge one another when they need to borrow to fulfill their reserves, the FED rate (the discount rate does not come into play here) and then with the Bernanke FED there is the amount that the FED is actually paying the banks on their reserves. The second rate is something that is new because always in the past reserves have not been paid interest.

It is this second rate that has motivated banks to increase their reserves. It is free money in that they can take money from the FED at the FFR, virtually zero, and put it into their reserves and earn interest, no risk.

Bernanke did thing intentionally to prevent the FED injections of cash from entering the real economy and creating inflation. He would not have to follow Sweden’s example of negative interest rates. All he would need to do is stop paying interest on reserves. But then that would foil is scheme because the money would enter the economy and create stagflation.

Patrick Barron September 23, 2009 at 2:15 pm

In a sound money (commodity money) environment, an increase in the demand for money causes prices to fall. Falling prices of both consumer and producer goods becomes the foundation of the recovery, after all, people still desire things and eventually will take advantage of bargain basement prices. Fiat money pumping to prevent falling prices merely prolongs the recession.

Ernie September 23, 2009 at 4:43 pm

Thanks for the answers. Makes perfect sense.

Gerry Flaychy September 23, 2009 at 7:18 pm

Eric, what Shostack means, I believe, is that money serves only to exchange goods, not to exchange goods AND produce goods. So, adding money to the economy, will not by itself add goods to the economy.

P.M.Lawrence September 23, 2009 at 7:38 pm

What Keynes left out was what Pigou pointed out as an objection. The stock of nominal money doesn’t change in his scenario, so that someone still holds it. As people hoard money and nominal prices fall, this is equivalent to holders of nominal money receiving additional cash from helicopters (say). This Real Balance Effect or Pigou Effect gets things going again, if anything ever does paint things into a corner that way (it’s more likely that it would head that off in the first place). The thing is, the corrective effect starts small but then grows much faster than the things causing it; it can always get large enough to work.

Adam Odorizzi September 23, 2009 at 7:42 pm

Why is Frank Shostak so good?

Michael Dunton September 23, 2009 at 7:46 pm

I think it is important to remember the reason the Fed is expanding its balance sheet–to keep the bubble inflated long enough in order for Mr. and Mrs. America to take over. This mis-guided policy has boxed the Fed into a corner from which it can’t stomach the possibilities after exiting the pumping. Pump too long and we could fling ourselves into inflation and crash the dollar. Get religon and see the light of day to exit this hopeless cycle would bring us more asset deflation–something they are deathly afraid of. Until enough people in Washington see the fingerprints of the Fed on the financial mess, the medicine will never be taken and the delay in malinvestment liquidation will make the recovery increasingly harder.

The malinvestments have not been liquidated completely–the Fed seems to think they shouldn’t have to be. All those years of cheap money and malinvestment excess have to be reckoned with. The Fed’s pumping will add to the reckoning.

The way the Fed is playing around with things, we could have both deflation and hyperinflation in short order. The Fed is giving itself liquidity trouble by doing something they wouldn’t allow their regulated banks to do: buy gobs of long-term securities at high prices with short-term demand deposits. The result of this madness could derail us for years.

Ron Paul could get his way by default; the Fed could self-destruct without a single shot (legislation) being fired.

danny September 23, 2009 at 8:45 pm

M Dunton

“Ron Paul could get his way by default; the Fed could self-destruct without a single shot (legislation) being fired.”

I agree — especially if we have another leg down in the next 12-24 months. However, it is only a matter of time….

Mike C. September 23, 2009 at 9:20 pm

Ernie,

The link below is to a comic and humorous short story by Irwin Schiff which is a great primer on the Austrian business cycle for beginners; it explains the difference between money and real savings very well.

http://www.scribd.com/doc/7500410/How-an-Economy-Grows-and-Why-It-Doesnt-Irwin-Schiff

K Ackermann September 24, 2009 at 1:36 pm

And then there is the matter of the Fed paying interest on excess reserves.

Why not just mop them up? The banks are healthy, right?

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