Global Grand Policy Failure: Liquidity Traps and Financial Black Holes   (August 9, 2011)


"We are all Keynesians now," indeed. Keynesian policies have pushed the global economy into a financial black hole.

What we are experiencing is Grand Policy Failure on a global scale, a failure best understood by examining liquidity traps and the Keynesian plummet into Financial Black Holes.

What is a liquidity trap? Here's Wikipedia's definition:

The liquidity trap, in Keynesian economics, is a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply. Liquidity traps typically occur when expectations of adverse events make persons with liquid assets unwilling to invest.

Here's what that means in the real world. I have $100 in liquid assets, i.e. cash, I saved from my income. I could leverage that by borrowing $1,000 at low interest and devoting the $100 to service that new debt ( i.e. make a future monthly payment), but since my future income is in doubt, I have no desire to take on more debt, even at zero interest. How do I know if my income will enable me to pay back the principal?

I could spend the $100 on discretionary purchases, but since I have everything I need to get by and my future income is doubtful, I prefer the security of savings over the marginal return of owning more gewgaws.

I could use it to hire an assistant (presuming I'm self-employed or in business), but since revenues have been unpredictable, I'd rather work a few extra hours myself and keep the $100.

I could spend the $100 on some new software that might make me more productive, but why bother when business is at best flatlined and at worst, in a freefall?

That's a liquidity trap: those with cash and the ability to borrow have no desire to either spend or invest in new employees or business assets. Their cash (liquidity) is "trapped" in the sense they have no desire or need to spend it or invest it.

In standard Keynesian economics, the only thing holding back a tide of spending and investing is lack of faith in future growth.

This is of course wrongheaded. Keynesianism is blind to the black hole of debt: at a certain threshold (event horizon), the ability and/or willingness to borrow more vanishes. No amount of monetary easing or shoveling new money into banks can spark new debt and spending.

Keynesianism is also blind to the necessity of debt renunciation/forgiveness: the key to freeing up new spending and investment is not shoveling more liquidity into the system, it's blowing off all the bad/impaired uncollectible debt in the system, wiping out borrowers and lenders alike (recall that one man's debt is another man's asset).

That would mean wiping out the "too big to fail" banks, and for some reason the Keynesian cargo-culters (Krugman, Reich et al.) never once propose the renunciation of impaired debt as part of their "solution."

Keynesians also fail to see the black hole of delegitimization: one reason why nobody wants to spend or invest is the credibility of the nation's financial institutions has vanished into the black hole of lost legitimacy.

Now that institutional credibility has fallen below this critical threshold, it cannot be recovered without deep structural transformation that includes severely limiting the political and financial power of Wall Street and the "too big to fail" banks.

Since that's never on the Keynesian agenda, what we have instead is three failed policies, not just in the U.S. but globally. Finding a Prescription for the U.S.'s Money Trap: Three fixes to the "liquidity trap" (WSJ.com):

One, the classic Keynesian prescription is for the government to borrow (after all, rates are low and savings idle) and spend to create demand and jobs.

Two,Lars Svensson, now deputy governor of the Swedish central bank, sees one "foolproof way of escaping from a liquidity trap"ódevalue the currency. "This will jump-start the economy and escape deflation."

Three, the interest rate that matters in the economy is the sticker-price rate adjusted for inflation. So some economists argue that the way out of the trap is for the Fed to convince everyone it's going to create more inflation. If inflation goes up and interest rates don't, then the inflation-adjusted interest rate falls, and that will give people cause to borrow and spend. Incomes rise with inflation, debts wouldn't, and they'd be easier to pay off.

All three Keynesian policies have been tried, and all three have failed completely. The massive "shovel-ready" fiscal stimulus caused a minor blip up in activity, but it did not spark any regeneration of borrowing and spending. All it did was enable further deleveraging as consumers and businesses struggled to pay down their crushing debt loads.

As for devaluing the currency, the Fed's policies devalued the U.S. dollar 32% from the early 2000s, and 17% from 2008. Rather than spark a boom of spending and investment, this massive devaluation sparked a dramatic loss of purchasing power which households experience as high inflation.

No nation ever prospered in the long-term by devaluing its currency. Devaluation is just another Keynesian "quick fix." Borroing 40% of Federal spending didn't "fix" what's wrong with the economy? Then borrow 50%. That devaluation wasn't enough? Then takes the dollar down another 10%. These are the policies of debt-junkies, not legitimate long-term growth based on capital formation and productive investment.

As for inflation being the "solution," the Keynesians forgot that vast, systemic labor surpluses mean that wages and incomes don't rise with inflation, except for the top 10%. So rather than force people to spend, spend, spend, that higher inflation so beloved by Keynesians has sapped the purchasing power of the bottom 90% of households which have seen their incomes stagnate or decline for years.

Solution 1: Central State fiscal stimulus: failure.

Solution 2: central bank-induced currency devaluation: failure.

Solution 3: central bank-induced inflation: failure.

Every textbook Keynesian solution to escape the black hole of liquidity entrapment has been tried on a grand scale, and failed on an even grander scale.

The solution is simple: renounce/write down all impaired debt, wipe out the "too big to fail" banks, and restrict the reach and political power of the remaining banks and Wall Street.

Until we're willing to do that, then the liquidity trap will remain a black hole that the economy cannot possibly escape.


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