Moving beyond definitions, how do we view the current US credit situation?

In a blog entry from today I took issue with Paul Krugman and argued that the US is not (yet) in a liquidity trap, but in a credit crunch. I think it is an important discussion because you need to know what sort of problem you're facing to know how to deal with it.

Of course, a liquidity trap is just a word, and in a response that seems directed at my discussion, Professor Krugman today writes that:

"Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story."

If we use that definition I agree that the US is most likely in or near a liquidity trap. Of course we can't actually know yet if the lowering of the fed funds rate to essentially 0 will have been effective, considering the long lag between central bank action and macro economic effects, but I side with Krugman in thinking that it isn't nearly enough.

However, the liquidity trap is not just any term term that Professor Krugman has defined himself. A liquidity trap is a nearly mythical term and is generally viewed as an extremely severe condition for an economy, and one that is very difficult to escape. Professor Krugman is currently arguing very strongly for more government stimulus and he is using the fear of a liquidity trap in his arguments for enacting a very large government-spending based stimulus package, because, in a liquidity trap, the general view is that there's not much you can do but to let the government spend.

If we are in a situation in which private economic actors would hoard cash even if they could borrow funds at almost 0%, that would indeed mean that we are in a very severe situation, in which oversized government spending would be an obvious solution. If noone else will invest and spend, let the government do it. In this situation monetary policy is useless and tax cuts are also quite meaningless. If we are in this situation, Professor Krugman's prescribed medicine is the only one that can work.

If, however, we are in a situation in which interest rates near 0% for individuals would actually make private spending and investment increase, the trade-off between trying to support private spending and investment, and only using government spending, becomes slightly different. This is not nearly as severe a situation, whether we call this a liquidity trap or not, and it is a situation in which more than one path can lead to recovery, which is not something that Professor Krugman acknowledges.

In this situation you have options like the use of monetary policy, adjustments to the transmission mechanism and the use of tax cuts to help handle the situation. Understanding whether you have these options or not is not meaningless.

I might add that I do think a large stimulus package is currently warranted, if nothing else then because of the fact that we do not quite know if we need one. I also believe that we need to focus more on the transmission mechanism. We should not let ideology stop the creation of a better credit system.

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It seems to me that the real key here is employment opportunity and I include entrepreneurialism in employment. In the current disaster it is opportunity that is lacking and government spending is the only politically viable immediate cure. There are other longer range adjustments that are may be beneficial to a sustainable economy but they are not presently politically viable and/or they will not produce results quickly enough. As to a trade off between tax cuts and government spending, the spending is going to win the debate hands down because the tax cuts will not create employment opportunity and demand quickly enough and such cuts have already been tried and have failed.

Tax and rebate systems need to come to the fore such as a high tax on carbon and a small tax on imports with all of the collected funds simply rebated to the citizenry in the form of a "direct stimulus". The quarterly distribution can be as an egalitarian citizen's dividend or in the form of the last "stimulus" (tax rebate). Accountable and responsible governments work at the macro level but are not tied to simple progressive tax levels and monetary adjustments. Accountable and responsible governments seek to improve the performance of the economy through taxing bads and letting the market find the microeconomic winners.

Posted by Michael Coburn on januari 26, 2009 at 11:34 em CET #


I do agree that the sort of tax cuts that have been done in previous stimulus packages have been quite pointless and I am generally negative towards tax cuts that contribute to a budget deficit.

However, in the current situation, I do think there is room in a stimulus package for selected tax cuts. With the numbers we are discussing, I believe it will be a difficult task for the government to make smart use of every dollar and it makes sense to divert a part of the funds towards tax cuts.

As the swede I am, I would love to see selected smart tax cuts coupled with a large tax increase on carbon emissions. However I do think any tax on imports would be misguided and negative for global growth. A carbon tax would make it more costly to transport goods, which would actually help the fiscal multiplier, as well as help the environment.

I understand that it is policitally impossible to propose a carbon tax that takes the gas price in the US to EU levels however.

Posted by Sloped Mind on januari 26, 2009 at 11:43 em CET #

I don't think there is any daylight between you and Krugman as long as you acknowledge that conventional monetary policy transmission allows the Fed to only buy/sell Tsy Secs/repos.

PK wrote:

"This time, however, the transmission mechanism is broken.

First of all, while the Fed can still print money, it can't drive interest rates down. Why? Because those interest rates are already about as low as they can go. As I write this letter, the interest rate on Treasury bills is 0.005 percent — that is, zero. And you can't push rates lower than that. Now, you might think that zero interest rates would lead to an orgy of borrowing. But while the U.S. government can borrow money for free, the rest of us can't."

I appreciate that you have started discussing how the monetary transmission works in Sweden. For some reason we don't seem ready for the debate on how to redesign the U.S. transmission mechanism even though Ben B. has already started making major adjustments.

Hopefully a few American economists will refrain from jumping into the fiscal policy political fray and stick to their knitting. A monetary policy redesign could use an economist's perspective before all remaining ammunition is either gone or becomes irrelevant due to a massive fiscal stimulus. The current situation presents an opportunity to create a permanently improved economic system as your variable home loans suggest.

So far, all I hear from economists is something about a 'swedish style nationalization' followed by a reprivatization of all banking functions. Basically no change.

Posted by Winslow R. on januari 27, 2009 at 07:50 fm CET #

There is a seemingly highly overlooked major point related to the demand management policies (of whatever nature), probably because of the way historical standard macrotheory has taken from its starting point onwards.

Such a way may be told of as one concerning domestic issues in spite of international (open economy) issues.

Take the classical (General Theory) Liquidity Trap: even when Keynes had not fully (or not at all) described its open-economy side, the trap does belongs to a sort of world-aggregative economy, i mean, to a a closed economy only by taking the closure as the one it can be (only) by summing up the several countries economies (or at least, the major economies).

Take the Great Depression: private global effective demand falls in such an "internationally" closed economy. The GDP falls all-around the World. When so happens, ex-ante (World) foreign trade ratio tends to grow while the earth´s GDP is falling.
Thats the reason why some time after that, almost every country will try to set either import-taxes or foreign-trade barriers (if not just devaluating exchange rates).

Now take the private effective demand slump at each country and its counterpart in terms of liquidity preference (say, capital markets bearishness on private corporate bonds markets, at each country): in a sense, so far as it had been realized that investment-returns ratios forecasts (and so liquidity expectations) linked with different corporate-bond subsets has everything to do with a multi-country-closedly economy, it could be recognized the fact that either single-country monetary-policy failure, or fiscal policy need, are both related to a situation in which private investors are not enough acknowledged or aware of a multicountry (political economy) path AT ONCE.

So as they are not to be expected to approach that path at once, effective demand will fall all-around the World.

I mean, the EU stabilization-policy success debate surely ought not to be abstracted from the worries about long-run or even mid-run foreign-trade concerns, globally undestood, so far as it be clear that only within the midst of that complex are the reasonably accute or well-informed future-investment-returns forecasts going to come through.

From this point of view, the fiscal-monetary alternative of US stabilization policy will be, if meant to have any success at all, completely linked with the policies of countries such as all those in Asia.

So it seems that the situation is a very difficult one, as if it could be expected no such a thing as an intercontinental agreement on the foundations of the world economy, and even that this may easily turn whatever US stabilization-policy to its own ineffectiveness.

Posted by willi on januari 28, 2009 at 04:35 em CET #

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