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Tuesday, January 14, 2020

America and the Liquidity Trap, Part 2

The Federal Reserve and the U.S. Treasury have worked together to effectively neuter monetary policy. Unlike in the past, in the next recession the Fed won't be able to do much of anything to help.


In the first article on the liquidity trap I pointed out that an expansion of money supply eventually loses its effectiveness as a policy instrument. Plainly, the economy is saturated with liquidity. To some degree, money printing (point b in Figure 1 below) and its reduction in interest rates (point a) has a positive effect on economic activity, but once the saturation point is reached, the economy will not respond to any further cuts in the interest rate:

Figure 1
Figure 1 illustrates the point when an economy enters the liquidity trap. Once there, it will inevitably drift toward the point when hyperinflation sets in.

The problem for economists is not to explain why the liquidity trap is a precursor to hyperinflation. The problem is to explain when the journey from one to the other is complete. A good part of the problem lies in limited understanding in mainstream theory of prices (and the conditions under which they change) and of the role that government debt plays in igniting hyperinflation.

We are not going to look in depth at both of these today; there is room only for the first. To get there, we need to add inflation to the picture presented in Figure 1. The analysis above implicitly assumes that there is no inflation effect from money printing, an assumption that is not meant to refute the inflationary consequences of monetary expansion. It is merely an analytical method known as ceteris paribus (all other things equal) that helps us understand the essential mechanisms of monetary policy. Therefore, let us now bring inflation into the picture.

Many critics of monetary expansion make the valid argument that money printing leads to big inflation numbers. We have several historic and contemporary examples to show that, from the Weimar Republic to Argentina, Zimbabwe and Venezuela in the 21st century. At the same time, we have compelling examples of how money printing does not lead to inflation. Under Bernanke's stewardship the Federal Reserve the U.S. money supply expanded significantly, compared to money demand, which in Figure 2 is represented by current-price GDP:

Figure 2
Sources: Federal Reserve (M1), Bureau of Economic Analysis (GDP)

Inflation, on the other hand, was almost entirely absent. In fact, let us include consumer-price based inflation in the next chart, reporting data from the euro zone. Here, we compare the growth rate in M1 euros to the so-called HICP, or harmonized index of consumer prices (a.k.a., CPI) and current-price GDP (consisting of real euro-zone GDP growth plus consumer-price based inflation):

Figure 2
Sources: European Central Bank (HICP, M1), Eurostat (growth raw data) 

While money-supply growth has remained high, inflation has actually tapered off somewhat in the euro zone. On average, per decade (with 2010s running through end of 2018), the numbers are as follows:

HICP M1 Current GDP
2000s 2.10% 7.80% 3.49%
2010s 1.37% 7.08% 2.74%

How is this possible? After all, the traditional monetarist equation...


...suggests an instantaneous relationship between money supply (M) and prices (P). Schematically, over time, the inflation rate should track the growth rate in money supply:

Figure 4

Which, again, it doesn't. One problem with the quantity-theory monetarist equation is that it relies on unrealistic assumptions, especially regarding V (the velocity of money) and Q (GDP). These variables are - for good reasons - assumed to be rigid in the short run and only change over a longer term. By simple deduction this leaves P as the only variable responding to changes in money supply. 

Simplification is never wrong, but in this case it omits the fact that prices are not at all as flexible as the quantity-theory, or monetarist, equation demands. On the contrary, prices change only slowly, with two price "reviews" per year as a good benchmark. This keeps inflation from responding to short-term changes in the economy.

In other words, prices are sticky, but not for the reasons that mainstream economics literature suggests. The reason is instead that it is rational to keep prices constant: it gives businesses a sense of predictability in their production, employment and investment plans, and it gives consumers the ability to foresee their cost of living. 

As a result of rational price rigidity, it takes a while for inflation to penetrate the economy. When, on the other hand, businesses change their price-setting behavior to accommodate for growing uncertainty in the economy, the inflation trajectory changes rapidly, and mercilessly:

Figure 5

Unfortunately, there is not much research on the timing of hyperinflation, especially with the sticky-price rationality incorporated. Therefore, it is practically impossible to predict when an economy reaches the point where inflation leaves its stable zone and goes ballistic. Most research simply focuses on validating or refuting the quantity-theory monetarist equation, a worthwhile cause in itself but not something that helps us with the timing issue.

Sticky-price rationality is not the only aspect on this problem that has been left out of most of the literature. The real culprit here, government debt, is practically never mentioned in the context of hyperinflation timing. It is an issue we will have to return to in a separate article; briefly, the main reason why central banks in both the United States and the euro zone have printed such exorbitant amounts of money in the past decade is that they want to finance unending government deficits. 

This has kept some tax hikes off the table, but it has not improved the long-term performance of the economy. Therefore, as government pumps out freshly minted currency through its deficits and entitlement programs, the economy is still being saturated with liquidity. Once the saturation point is reached where money supply no longer has any effect on the economy (Figure 1 above) and government keeps borrowing, we should reasonably expect the inflation curve to bend upward any time, and do so with a vengeance (Figure 5).

In short: by not getting its fiscal house in good order, Congress is playing with hyperinflation matchsticks. 

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