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How to escape the liquidity trap Samuel Brittan: Financial Times 28/03/03 The hottest topic among highbrow financial analysts is: what can be done if official short term interest approach zero but are still not low enough to revive an economy? Have the central banks then "run out of ammunition"? The issue could arise if the end of the Iraq war is not sufficient to galvanise the animal spirits of business and world economies remain sluggish. The question has become serious enough for the Bank of England to include in its Spring Quarterly Bulletin an article by a senior official Tony Yates on the subject. Last November B. Bernanke, a new Fed governor, gave a well publicised lecture entitled "Deflation: making sure it doesn't happen here." The problem is quite easily stated. Short term nominal interest rates cannot fall below zero, as no-one would have any incentive to lend at negative rates. In fact the problem is worse. For most businessmen cannot borrow at the best prime rates but have to pay a couple of percent more to allow for commercial risk. In the 1930s Lord Keynes suggested that the lower bound to interest rates - which he called a liquidity trap - might prevent monetary policy from being sufficiently effective to restore normal output and employment. Milton Friedman in his post-war reply did not deny the theoretical possibility of such a trap. His view was that the Fed could have increased the money supply in 1931, but chose not to do so. The historical controversy still rages. Mr Yates is also anxious to play down the likelihood of such a liquidity trap. He tends, perhaps too easily, to dismiss the US in the 1930s and Japan today as suffering from conditions remote from the present day UK, where interest rates could still fall several percentage points. He reinforces this by a consideration of various economic models purporting to show in what a small proportion of time an economy would be subject to the zero interest rate bound at varying, but low rates of inflation. But he does not really expect his readers to be reassured. One tempting way, which he mentions only to dismiss, of preventing the liquidity trap from arising would be to aim at substantial inflation rates, so that real rates could become negative during periods of recession and stagflation. This may indeed be one of the reasons why the world did not go into prolonged deep recession after the 1973 oil shock. But he dismisses the idea as bringing too many disadvantages as well as being politically "not on". A popular course, frequently advocated for Japan, is pre-announced devaluation. This would both raise price expectation and provide a direct stimulus to exports. The biggest problem with this remedy is that it would be quite inappropriate if the threat of slump were international rather than confined to one country. The zero bound to interest rates seems most likely to strike next in the case of Germany where the single currency makes a national depreciation impossible. Yet it surely ought not to be beyond human wisdom to prevent or at least treat a slump in a world of unmet needs that unemployed workers could be used to supply. Governor Bernanke remarks: "If we do fall into deflation we can take comfort that the logic of the printing press asserts itself and a sufficient injection of money will ultimately always reverse a deflation." Friedman indeed once contemplated dollar notes dropped from helicopters. A more respectable suggestion is that central banks, instead of limiting their pump priming operations to very short dated government securities, should buy a much wider range of assets,including private sector bonds. The Bank of England author discusses whether such operations could be reinforced by central bank guarantees to maintain near zero interest rates for some period ahead. But unlike Governor Bernanke he wonders whether such guarantees would be either credible or desirable. The most unorthodox expedient he examines is a tax on money, if not spent by certain dates. This was proposed by academics a century ago, but is not as cloud cuckoo as it seems. When the Swiss were trying to repel short money inflows ago they imposed a tax on overseas held bank deposits. This surely could have been extended to cover domestic deposits as well. Admittedly notes would have been a more difficult proposition, but not impossible with modern electronic means. In discussing remedies the Bank of England analyst mentions first fiscal policy, that is tax cuts or public spending boosts. But this does not get the Bank off the hook altogether. For the effects of such stimuli would be controversial and uncertain unless they were financed by monetary creation rather than by long term borrowing. As governor Bernanke argues: "A money financed tax cut is essentially equivalent to the helicopter drop." Both EU rules and Gordon Brown's monetary and fiscal framework appear to rule out such expedients. But all these rules could surely be bent if the world were faced with utterly different dangers to those feared at the they were drawn up. The real problem is that monetisation of a new flow of public debt requires, as Adair Turner of Merrill Lynch has reminded us, "co-ordination, us between fiscal and monetary authorities, and that would be more difficult to achieve with one central bank and 12 fiscal authorities". This is one further reason for countries outside the euro to stay outside for some time to come. My own preference would be for temporary cuts in consumer taxes, which would be reversed automatically at a stated date. This would be adequate to fight a temporary recession and not require unorthodox financing. In the face of more deep seated stagnation or slump something more would be required. The obvious weapon would be public investment. The hole in the economy would arise because of the failure of private investment to keep up with attempted savings. So it would be sensible for public projects to take up the slack as Keynes originally suggested to Lloyd George. There is an obvious danger of crying "wolf" too soon and bringing back inflation or overblown government spending through errors of pessimism. But the best defence against such panic reaction is the knowledge that the authorities have in their cupboard weapons for coping with deficient as well as excess demand.
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