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The new liquidity trap

March 24, 2008 09:05 IST

A major component of the text-book Keynesian macroeconomic paradigm was the "liquidity trap". Essentially, this term was used to describe a situation in which investors choose to hold their entire portfolio in cash.

As a result, any further infusion of liquidity into the system by the central bank is simply sucked up by these investors, rather than being invested in other assets, such as bonds. If bonds are not bought, their prices and, consequently, yields, remain constant.

In short, increasing liquidity does not translate into lower interest rates. Monetary policy, therefore, cannot generate growth impulses. The description of monetary policy as "pushing on a string" originates from this situation.

Admittedly, the trap was an extreme characterisation of portfolio behaviour and more sophisticated articulations of Keynesian macroeconomics did not belabour it. However, it has occasionally come back into the policy debate, although from a somewhat different perspective.

Rather than arguing that there is a floor, below which interest rates will not decline, the appropriate way to frame the issue seems to be: is there a conceivable situation in which, even if interest rates go as low as they can, there will be no takers for credit? If so, the Keynesian scepticism about the ineffectiveness of monetary policy in taking the economy out of recession remains valid.

We saw shades of this in the extreme sluggishness of the Japanese economy   until about three years ago, when it re-entered a positive growth zone. Even when nominal interest rates turned negative (real rates being zero), there simply wasn't enough appetite for borrowing.

Eventually, the growth stimulus came from elsewhere; buoyancy in the rest of Asia and the renewed demand for fuel-efficient automobiles in the US, for example. However, the ineffectiveness of interest rate policy in stimulating growth when the financial system simply cannot find people to lend to.

Is the US economy and, by virtue of deep financial integration, the global economy, now in a similar situation - a liquidity trap? The frequency of use of the expression "pushing on a string" in the public debate is one indicator that it is. And, more objective evidence seems to be piling up.

Notwithstanding the 125 basis point reduction by the US Federal Reserve Board in January, the complete lack of activity in the markets for many financial assets is forcing financial institutions around the world to devalue their holdings.

It doesn't really matter whether these assets represent direct exposure to the sub-prime housing loan segment or not. As long as they are viewed as reasonably close substitutes, the decline in prices of one category of assets will necessarily result in a decline in prices of the others.

Two consequences of this development are critical. One is already visible, the other is in prospect. The first is that institutions with the highest exposure to the relevant category of assets will inevitably fold. If they had not passed on the risk before, there is really no way they can do it in the current market circumstances.

The developments at Bear Stearns are illustrative of this and have left many people certain that more such collapses are to follow. If this does happen, it would clearly be a liquidity trap in a new financial age, reflecting the inability of monetary policy to influence prices and returns on a whole range of financial assets.

What was a simple two-asset model - money and bonds - in the original Keynesian formulation of the liquidity trap has now become a far more complicated one, but the result is essentially the same. More money does not necessarily influence financial market outcomes.

The second consequence relates to the degree of substitutability between different categories of assets. As was evidenced by the response of the equity markets to the US Federal Reserve's cut of 75 basis points in the federal funds rate last week, some assets are still responsive to an infusion of liquidity.

The implication is that the new liquidity trap is, at least so far, segmented in its reach. It has a number of categories of assets in its clutches but has spared some other, critical ones. But, a whirlpool effect is still very much a possibility.

Ultimately, all financial assets are substitutes for each other; their proximity differs only in degree. If the liquidity trap begins to expand its grip on new categories of assets that bridge the gap between the currently affected and the currently immune, it is only a matter of time before they all enter the whirlpool.

How does one get out of a liquidity trap? Text-book Keynesianism and recent Japanese experience have both shown us. The trick is to find an external source of demand that is completely autonomous of the current state of the economy.

Massive government spending, financed by future tax revenues, contributed its bit to getting the Western world out of the Great Depression. Rapidly growing exports helped Japan come out of its long hibernation.

The US fiscal policy response, a $160 billion consumption-oriented stimulus package, is entirely in line with this reasoning. That it will have a positive impact is unquestionable. What is less certain, though, is whether it will be large enough and quick enough to resist and eventually reverse the force of the whirlpool.

The more direct intervention, which both the US Federal Reserve and other central banks are already attempting, is to narrowly target liquidity infusions at the more vulnerable asset classes. Expansion and liberalization of various lending windows, which essentially allows financial institutions to borrow against assets which the market will not accept, is already under way.

The Bear Stearns rescue took this to another level by moving from asset classes to the portfolio of an individual institution. But, the risks associated with this approach are obvious. If these targeted interventions do not work, the whirlpool will intensify as more assets fall into the trap and, consequently, more institutions are dragged down by it.

If these approaches do not work, the only recourse left is to prop up the prices of the securities currently close to the vortex. This implies that governments in affected countries will have to pool resources to make a market for these securities, paying a "fair" value to financial institutions for them in return for significant improvements in investment practices, prudential norms and disclosure.

The costs, in terms of fiscal commitments, moral hazard and increased regulatory load, have to be weighed against a potential meltdown of the global financial system. But, who is going to make that call?

The writer is Chief Economist, Standard & Poor's Asia-Pacific. The views are personal

Subir Gokarn