A different liquidity trap

An introductory course in macroeconomics covers the basic characteristics of a liquidity trap (LT): the interest rate set by the Federal Reserve is close to zero; and the economy is barely growing and those in charge of setting monetary policy are unable to get it jump-started. So people decide that keeping their assets in cash is a much more desirable alternative to making investments, resulting

An introductory course in macroeconomics covers the basic characteristics of a “liquidity trap” (LT): the interest rate set by the Federal Reserve is close to zero; and the economy is barely growing and those in charge of setting monetary policy are unable to get it jump-started. So people decide that keeping their assets in cash is a much more desirable alternative to making investments, resulting in an economy that remains stagnant or falls into a recession.

I think we need to consider an alternative liquidity trap (ALT), whose consequences can be even more damaging. An ALT occurs when cash is so plentiful that people seek more speculative investments and do so aggressively and over a long period of time (at least eight consecutive quarters). In order for cash to be plentiful, interest rates must be relatively low, which is the case when we're in the midst of an LT.

More importantly, the difference between short-term rates and long-term rates has to be very small by historic standards. This means that investors can borrow money over a longer period of time at rates that reflect a high degree of certainty about the future and an expectation that inflation will be minimal over the period of the loan. These factors combine to set the trap for the hare.

I recall a trip to the Middle East in the mid-1960s where I heard a parent asking his son why he was spending all of the money he had saved. The son's answer was that since inflation was so high it made sense to spend the money as soon as possible. While at first this may seem irrational, it really is a sound economic choice given the conditions at hand, i.e., high inflation.

Of course, in order to feel comfortable spending you must also have confidence that your income will keep pace with inflation and that you won't be hit with any unanticipated expenses.

This situation is really the flip side of the LT in that people do not hoard their money and thus keep the economy moving.

Recently, the ALT has caused investors to seek havens for their excess cash. The excess cash first accumulates within financial institutions and among off-shore investors. It helps if the off-shore investors have no reasonable alternative for their investment funds. In recent years it made sense to invest in U.S. financial markets and transferable assets, i.e., real estate and other kinds of property, to maximize returns at relatively low risk.

Consequently, we saw a run-up in the value of domestic assets, primarily property and stocks, leading to an increase in the wealth of those who held the assets. People then made the pretty rational decision that since their wealth was increasing, so could their spending. The wrinkle in their logic, however, was that their wealth was composed of assets that are subject to revaluation — big time.

Remember that the ability to acquire funds at low interest rates for long periods of time led to an exuberance that brought out some extremely creative — and risky — lending contracts. In addition, financial intermediaries began to appear who had little or no experience in the world of consumer financing. What happened next was that liquidity increased at a rate faster than economic resources could absorb and sustain their values.

So we had more cash chasing fewer qualified borrowers. That was the liquidity part of the ALT. The trap was that as lenders pushed their liquidity into the market, they had to attract non-traditional, or less qualified, borrowers to absorb it.

Defaults occurred not only in home mortgages, but also in financing for consumer durable goods. Both foreclosures and repos are well above historic averages, with no end in sight this year.

The hare has been caught.

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