Since this blog entry is about the US, I have chosen to write this entry in English. The regular Swedish programming will return shortly.

UPDATE: Added a couple of sentences on the credit crunch versus liquidity trap discussion. The new paragraph found below reads "An economy can be in a situation in which a certain minor sector of the economy experiences a credit crunch, while the rest of the economy experiences a liquidity trap. However, if major sectors are in a credit crunch, the economy as a whole can not be considered to be in a liquidity trap."

UPDATE 2: In a new entry, here, I discuss today's entry by Paul Krugman, in which he takes issue with bloggers like me, who discuss whether the US is in a liquidity trap. To avoid a debate on definitions, I try to move beyond the word "liquidity trap" and look at the existing situation.

In US macro economic debate, there is currently a lot of focus on the benefits of various forms of stimulus and on what the state of the economy actually is.

The debate has degenerated into a political cage match in which normally very articulate professors make very crude and naive comments. It seems that economists currently do not believe in presenting a reasonably balanced picture based on modern economic research by researchers belonging to different schools of thought. Instead, most economists seem to present an extremely simple picture, based on a very narrow set of assumptions that fit their own political view, without caring at all about any research results pointing to other realities.

Much criticism of conservative economists has been offered by Paul Krugman. In this blog entry Professor Krugman says that he is appaled by how a few named economists are behaving.

"Needless to say, everyone I’ve mentioned is politically conservative. That’s their right: economists are citizens too. But it’s hard to avoid the conclusion that all of them have decided on political grounds that they don’t want a spending-based fiscal stimulus — and that these political considerations have led them to drop their usual quality-control standards when it comes to economic analysis. Has there been any comparable outbreak of mass bad economics from good liberal economists? I can’t think of one, although maybe that’s my own politics showing. In any case, what’s happening now is pretty disturbing."

Professor Krugman has not seen the same kind of behavior from liberal economists, but I would argue that he has displayed this very behavior himself.

I am writing this as an outsider to the US macro economic debate. I normally blog about Swedish macro economics and monetary policy. Our political spectrum is not comparable to the US one, but by US standards I'm politically liberal. When it comes to macro economic issues I view myself as a moderate, being influenced greatly by a number of economists of different traditions and political views, and from my standpoint, it does seem like Professor Krugman is worthy of the same criticism that he launches on others.

Professor Krugman has taken an extremely positive stance towards using government spending to end the current US recession. He has not been discussing the problems with such a stimulus at all, probably believing that it's enough to just present one side of the coin and let the "other guys" present their side of the coin, and that that could lead to a meaningful debate.

If you believe that it's your job to argue for one side of the argument without regards to the problems related to what you argue for, you are not a scientist but a politician. The debate Professor Krugman is taking part in is clearly a political debate, not a scientific one, and the arguments he makes has nothing to do with economic research or science, but only with politics.

He presents some extremely naive models that discard some of the fundamentals of macro economic analysis and science, without so much as mentioning why he would find this suitable to disregard.

One example is the model he presents regarding optimal fiscal policy in a liquidity trap, in which he argues that crowding-out during a liquidity trap is zero or extremely low until you reach full employment, and then exactly when the last person has been employed to reach full employment, the crowding-out effect soars instantly as the fed starts hiking the interest rate. In his own words he says that:

"If G is low, so that monetary policy cannot achieve full employment, the marginal cost of an additional unit of G is low, because the additional government purchases don't crowd out private spending. Once G is high enough to bring full employment, however, any further rise in government purchases will be offset by a rise in the interest rate, so that extra G does come at the expense of C, implying a jump in the marginal cost. As the figure suggests, there should be a fairly wide range of situations in which the optimal level of G is precisely the level at which the marginal cost jumps – that is, the optimal fiscal expansion is one that brings the economy right to full employment."

This is at best naive. One of the fundamental differences between micro economics and macro economics is that events that are binary in the micro world, become continuous functions in a macro world. In the micro world a single employee at a certain point in time is either fully employed or not. In the larger world of many people, many business sectors, many regions and many skill sets, you will always find some groups of people that see full employment, some groups that have more than full employment, some groups that are very far from full employment. For every stimulus dollar that is spent, the risk that the next dollar will affect a "tight" resource that would be used by the private sector if the government didn't use it, increases. This is an obvious risk that you can not disregard.

You can argue that smart government stimulus can limit the crowding-out effect, but saying that "additional government purchases don't crowd out private spending" without explaining how this would magically be the case just because an increase in G would not mean increased interest rates is not what I expect from a first class economist. He fully ignores the fact that inflation pressures would arrive well before full employment unless the government spending is perfectly assigned to regions, sectors and skill sets with available resources. This is an assumption that is as naive as the idea that all people are rational.

Professor Krugman is also discussing only one side of the issue when it comes to where the economy is today. Professor Krugman is taking the fact that the US is in a liquidity trap for granted, and that the US is wrestling with the zero-lower-bound for interest rates, even though there are obvious reasons for why you would argue that the US is not in or near a liquidity trap.

A liquidity trap is essentially a situation in which economic actors will hoard cash rather than make purchases and long-term investments, even though they get no interest on the cash they hoard and they can borrow money at nominal interest rates at or near 0%.

Neither of these two basic attributes of a liquidity trap are accurate when it comes to the current US situation.

First of all, the economic actors are not exposed to 0% interest rates. No final loans to private individuals or companies are made at or near a 0% interest rate. We do not know what would happen if people could borrow at rates near 0%, but if you believe the US is truly in a liquidity trap you must believe that the US savings rate would increase rapidly even in the event of people getting 0% on their savings and being able to borrow at something like 0.5%. Until we can actually see interest rates near 0% for actual private borrowers, we can't possibly be in a liquidity trap, although we might be at the risk of ending up in one.

Secondly, the savings rate, although rising, is still historically low, which means that people are not hoarding cash to a great degree. The demand for cash and cash-like instruments like treasury bills seems to be related to deleveraging by financial firms forced by big losses, and not by people who believe cash will be a good investment at a 0% nominal yield because the deflation will be big enough to create a large real return.

There is another phenomenon, that is not a liquidity trap, but that can also create disinflation and even short-lived deflation. The phenomenon is a credit crunch. In a credit crunch credit becomes hard and/or expensive to come by, and this dampens the willingness to borrow, spend and invest. The difference between a liquidity trap and a credit crunch is that in a liquidity trap people have ample access to cheap credit and still choose to not borrow money, while in a credit crunch people do not borrow money either because they can't or because they view borrowing as too expensive. The basic attributes of these two phenomena are such that they are mutually exclusive. In a credit crunch you have limited access to cheap credit, in a liquidity trap you have ample access to nearly free credit; you can't really have both.

An economy can be in a situation in which a certain minor sector of the economy experiences a credit crunch, while the rest of the economy experiences a liquidity trap. However, if major sectors are in a credit crunch, the economy as a whole can not be considered to be in a liquidity trap.

To me it is quite clear that ths US is currently in a credit crunch and not in a liquidity trap, although nothing guarantees that one doesn't give way for the other; when the credit crunch is over and people get good access to cheap or free credit, we will see if people refuse to borrow money.

So, if the US has a credit crunch, what can be done on the structural level to stop this, and can these solutions lower the risk of future credit bubbles and credit crunches? This is a huge area of debate and I will not be able to get into all the details in this blog entry. However, I do want to give some reflections based on the experiences from Sweden.

I think one key issue that is not very visible in US macro economic debate, but which is obvious to an outsider, is the fact that US credit markets are organized in a way that makes effective central bank intervention extremely difficult.

First of all, mortgages are essentially fixed rate products, and with fixed I mean mortgages with interest rates that reset less often than every 3 months. Yet, the Federal Reserve does not target the long term interest rates, but the overnight fed funds rate. Changing the overnight fed funds rate has a relatively small effect on the actual rates that real people can find when getting a mortgage, even if they choose an ARM product.

In my country, most mortgages have interest rates that reset every 3 months or more often. Some are even adjusted on a daily or weekly basis. With a policy rate (the repo rate) currently at 2%, most people pay somewhere between 2.4% and 3.5% interest rates on their mortgages. With every change in the repo rate, a majority of mortgage holders immediately or almost immediately see their rate change. This means that there is a very strong and immediate effect to rate changes. If the Swedish repo rate would be set to 0%, Swedish mortgage holders with good credit could actually get rates as low as 0,4%. You can not find rates like that in the US. In the same way, when the central bank hikes rates, the effect is also rapid. This makes it much easier for the Swedish central bank to stop credit bubbles before they get out of hand, and to stop credit crunches and liquidity traps with conventional monetary policy. The 0-lower-bound is not an issue that becomes relevant until actual mortgage rates are very near zero.

For the fed to have the same effect they need to go to unconventional monetary policy, which brings with it  a risk of creating large long-term imbalances. When Greenspan warned in 2003 that the Fed might intervene to lower longer term interest rates to stop deflation, the side effect was that long term interest rates fell below the market expectations for future short term interest rates. When you prepare the market for unconventional monetary policy to cut long-term interest rates, the market might keep pricing that chance in even in the long term, which means that low long term rates might live on long after the need for the stimulus is gone.

During much of the boom years, long term interest rates didn't react as much to the rate hikes as the Fed wanted them to, which meant that while the Federal Reserve increased their policy rate from 1% to 5.25%, long term mortgage rates moved very little.

As long as such a large chunk of credit in the US is based on a fixed interest rate, the central bank can not effectively apply conventional monetary policy to stop credit bubbles and credit crunches.

In the long term I do believe that stability is best achieved by moving credit to adjustable interest rates, to relieve the Federal Reserve of the need for wild fed funds rate swings and unconventional monetary policy.

But what can you do to get people to use mortgages with interest rates that reset at least every 3 months? Well, what makes people use these mortgages in Sweden? I believe that a few factors are of major importance.

First of all, I believe that prepayment penalties are key. In Sweden, if you pay off a fixed-rate mortgage before it expires, you have to pay for the interest rate differential between the fixed rate you're paying and the fixed rate the lender can get in the market by investing the money you lent in an equal investment. With 10 years left on a mortgage, this can work out to a very hefty sum. This means that the borrower who chooses to repay his mortgage in advance has to take all the costs of his prepayment and that the borrowers who do keep their mortgage until expiry, do not have to share the burden of other people making prepayments.

I understand full and well that prepayment fees are looked upon as something borderline evil in the US, but I believe they play a vital role both in making sure that borrowers actually pay for the mortgage they use, and to discourage people from getting fixed rate mortgages.

Secondly, I do believe that there should be no closing costs or points involved in getting a mortgage. This means that, as long as your mortgage is not a fixed rate mortgage, you can move your loan to another lender at any point in time, with zero cost. This promotes competition and promotes the use of adjustable rate products.

To make this work, you can not just implement these two things, or you would risk actually increasing the instability of the system. You also need to make mortgage recourse loans. You need to make sure that mortgage decisions are based on the verified income of the borrower, and not only on the assets of the borrower. With adjustable rates the income analysis becomes a lot more important since you have to take possible future interest rate hikes into account. If the property itself can not be used as the sole reason for why you can get a mortgage, the risk of credit bubbles decrease substantially.

Also, you need to make sure that you can not borrow nearly 100% of the property value. Finally, one thing that is desperately needed is new and strong regulation on what sort of mortgages that can be securitized. This also means that we can rather easily find solutions to how to get the other things to happen. New laws regarding the creation of mortgage backed securities could require that any mortgage packaged into an MBS fulfill the requirements I mention. It would be illegal to market mortgage based securities if they do not fully consist of recourse mortgages with prepayment penalties, no closing costs, a verified income that is high enough to handle the mortgage and a reasonable loan-to-value.

If this was to be implemented in the US, I believe the the federal reserve would have the tools necessary to better ensure sane credit availability and avoid the current boom and bust cycle.