Fears of a 30’s style liquidity trap

Fears of a 1930’s style “liquidity trap”

Will big cuts in interest rates avert the threat of recession for the United States? Interest rate reductions ought normally to provide a monetary stimulus to the economy supporting confidence and encouraging consumer spending and business investment. A well-judged relaxation of monetary policy should help to stabilise demand, output and jobs helping to reduce the risk of a painful economic slump.

But the Nobel-prize winning economist Joe Stiglitz has claimed that the United States may be on the verge of a 1930s-style “liquidity trap” which may make monetary policy decisions impotent. His argument is based on the divergent movement in long term and short term interest rates. Last week the US Federal Reserve cut short term interest rates by 0.75% (the largest single reduction in nearly a quarter of a century) - thus bringing down short term official interest rates. Stiglitz believes that longer-term interest rates such as rates on government and corporate bonds and mortgage rates will not come down as easily and it is this that might act as a depressant on the real economy. The credit crunch has driven up long term interest rates and bond yields are also being edged upwards by fears of rising global inflation, for example caused by persistently high fuel and energy prices and the end of a decade or more of cheap food.

If mortgage rates stay high, there will be little respite for a US housing market clearly mired in recession. Falling property prices will depress personal wealth and lead to a reduction in spending on goods and services. Negative equity may haunt many thousands of home-owners - where their property is worth less than their outstanding mortgage debt - and in this situation, lower short term interest rates e.g. on credit cards will do little to boost consumer demand. Stiglitz believes that in a liquidity trap two things can happen. Firstly that large changes in interest rates have little impact (the interest elasticity of demand drops close to zero) and also that the time lag between a relaxation of monetary policy and its eventual impact on aggregate demand lengthens. This makes it very difficult to rely solely on monetary policy as a way of managing demand. This is perhaps a cue for the size and scale of the tax rebates being pushed through by the Bush administration.

Even that may not be sufficient. Professor Stiglitz is reported in the Telegraph as saying:

“As a Keynesian, I’d say the biggest back for the buck in terms of immediate stimulus would be unemployment assistance and tax rebates for the poor. That will feed through quickly, but set against the magnitude of the problem, even a fiscal stimulus package of $150bn is not going to be enough. The (economic) distress is going to be very severe. Around 2m people have lost all their savings.”

Consumer spending accounts for over 70 per cent of aggregate demand in the US economy – a record high – and much greater than for most other advanced economies. The Stiglitz view is that the US recession is as much the result of macroeconomic mismanagement rather than a response to a series of negative external shocks.

“What we have now are the foreseeable consequences of bad economic management.”

Suggestions for further reading

Can the world stop the slide? (Time magazine) http://www.time.com/time/magazine/article/0,9171,1706763,00.html

George Soros: Britain cannot escape US recession (The Guardian) http://www.guardian.co.uk/business/2008/jan/24/recession.davos