Confusions over the economic outlook 2- the liquidity trap

At the end of Confusions over the economic outlook 1 interest rates, I said that I would next look at the liquidity trap. I will do so, but first a brief response to the discussion that followed that first post because it is linked.

The Comments

2 tanners suggested that the theory looked even more shaky if the banks simply increased profitability by not passing on interest rate cuts (as they appear not to be doing). This then freed them to make higher profits or support riskier speculation (e.g. in houses or stocks), neither of which generate real income.

 Winton wrote: "It seems that lowering the interest rate no longer has much effect on the exchange rate in Australia. I wonder what will happen if the whole world adopts exchange rate targeting as in Singapore." 

kvd initially focused on policy instability: "Sometimes I think that a government which simply announced that there'd be absolutely no major policy changes enacted for 10 years - i.e. what you've got is your predictable business and personal environment for the next decade - would be doing us all a favour. Instead", he suggested, "we're stuck in the vowels: avoidance of risk, exacerbated by
erratic political environment, leading to insufficient confidence, and then there's overregulation, all of which leads to unwillingness to invest."

Winton agreed:

kvd: That is a good point. Policy uncertainty looks to be a big factor behind the decline in investment in many high income countries over the last 15 years or so. It looks like we have low investment leading to low growth, increased job insecurity, the rise of xenophobia and hence greater policy instability.

However, I doubt whether we could have no policy change for ten years without a fiscal crisis. If no policy change Involved no increase in government spending in real terms it would actually be a major reform. 

In terms of monetary policy, no policy change would involve sticking to the inflation targeting rules we currently have. However, the Reserve bank seems to have a problem in convincing people that it has the means and the determination to meet those targets

Winton and kvd continued in general agreement. "Winton, I agree with your comments, except that instead of the publicised 'inflation target range' supposedly at the core of the RBA's activities, I'd make it a 'desired upper bound over the economic cycle' with no downside responsibility/action." 

Continuing a theme from an earlier comment thread, kvd also suggested that "inflation really is a stealth tax (it advantages both government and borrowers; both being users, not providors, of capital), so why give any sort of encouragement for government action which would seek to promote it in the event it falls below 'target'?" He was cautious about an exchange rate target: "would that not lead to artificiality, and hence vulnerability, in an economy as small as ours?"

Winton and kvd continued in agreement: "kvd, I agree that the idea that any amount of inflation can be optimal seems peculiar. The way I rationalise it is that because of quality change issues, price indexes tend to overstate the rate of inflation. So, our target band might not be too far away from zero inflation. We also need to consider expectations. If people have come to accept 2% p.a. CPI increase is the norm, it will take many years to persuade them that they should expect the rate of CPI increase to be 0% p.a. in future." 

Winton then expressed a concern about the Singapore approach. "It will be interesting to see how Singapore goes ... If we went down that path my concern is that the import-competing and exporting industries would always be lobbying the government to lower the exchange rate target to improve their "competitiveness". If the whole world does it, we will be in a world of competitive devaluations."

Finally, Jasper Gnomes wondered what the Reserve Bank actually did. 

Discussion

I have outlined the brief discussion on that first post at length because it raises a number of points germane to my argument.

The issue about that dreaded policy instability is something we have talked about here a fair bit. It affects macro-economic policy, but it is still more common in other policy areas. It creates confusion. I am reasonably bright and indeed have been a policy adviser on macro-economics, tax, finance and industry policy as well as aspects of social policy, but I get totally lost now. It makes planning difficult and, to the degree that policy success depends upon the expectations, it ensures policy failure.

 So we might well be better off freezing policy, accepting imperfections and just getting on with it.

On the question of inflation and inflation targeting and the associated question of what (if anything) to do about deflation is again something that we have talked about. The original idea that a central bank should set an inflation target actually dates back, I think, to the stagflation of the 1970s.

Thinking of Jasper, the Reserve Bank web site describes the Bank's role in these terms.

The Reserve Bank of Australia is Australia's central bank. It conducts monetary policy, works to maintain a strong financial system and issues the nation's currency. As well as being a policy-making body, the Reserve Bank provides selected banking and registry services to a range of Australian government agencies and to a number of overseas central banks and official institutions. It also manages Australia's gold and foreign exchange reserves. 

The role and functions of the Reserve Bank are underpinned by various pieces of legislation. The Bank is a statutory authority, established by an Act of Parliament, the Reserve Bank Act 1959, which gives it specific powers and obligations. In terms of the Act, there are two Boards: the Reserve Bank Board and the Payments System Board. 

The Reserve Bank Board's obligations with respect to monetary policy are laid out in Sections 10(2) and 11(1) of the Act. Section 10(2) of the Act, which is often referred to as the Bank's ‘charter’, says: 

It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:
a. the stability of the currency of Australia;
b. the maintenance of full employment in Australia; and
c. the economic prosperity and welfare of the people of Australia. 

Section 11(1) of the Act covers the need to consult with Government; "the Reserve Bank Board is to inform the Government, from time to time, of the Bank's monetary and banking policy." 

The ‘charter’ of the Payments System Board is defined in section 10B(3) of the Act as follows: 

It is the duty of the Payments System Board to ensure, within the limits of its powers, that:
a. the Bank's payments system policy is directed to the greatest advantage of the people of Australia; and
b. the powers of the Bank under the Payment Systems (Regulation) Act 1998 and the Payment Systems and Netting Act 1998 are exercised in a way that, in the Board's opinion, will best contribute to:
     (i)controlling risk in the financial system;
     (ii) promoting the efficiency of payments system; and
     (iii) promoting competition in the market for payment services, consistent with the overall stability of the financial system; and
c. the powers and functions of the Bank under Part 7.3 of the Corporations Act 2001 are exercised in a way that, in the Board's opinion, will best contribute to the overall stability of the financial system.

Sorry for the clunky formatting. 

Up until the 1970s, relatively greater weight was placed upon the maintenance of full employment. Further, fiscal policy - the use of the budget to manage levels of economic activity - was seen as more important than monetary policy. Monetary and fiscal policy were meant to work in tandem.

The stagflation of the 1970s - the combination of high unemployment with high inflation - effectively discredited fiscal policy as a tool. The focus shifted to monetary policy and reduction in inflation. This combined with another trend, the rise of the independent central bank. As part of this, inflation targeting became a key central bank objective. The aim was to get inflation down and then keep it an acceptable level.

During the Global Financial Crisis, fiscal policy came back, if in a fairly ham-fisted way. However, the policy settings and institutional structures that had developed made central banks and monetary policy the dominant instrument for trying to manage the crisis. One side-effect was a world suddenly awash with money. However, that cash could not find its way into,productive investment but instead found its way into assets. So we had a world of low inflation or even deflation, very low interest rates but inflating asset prices as the only game left in town for getting a reasonable rate of return. Now the central banks with their inflation targets were no longer concerned with getting inflation down to target, but actually getting it up.  

Now we come to the liquidity trap. I no longer pretend to understand the theoretical arguments around this, so let me give you the grossly simplistic points that I internalised when I first did macro-economics all those years ago in what now seems a different planet. 

You increase the supply of money. Part of that goes into new spend. With more money, interest rates also fall thus encouraging investment. But what if people want to save the money rather than spend it, what if  nobody wants to invest in new productive activities because the risks are too high, the returns to low.? Then the money supply increases but only goes into chasing assets with existing returns because there is no other game in town? Then you have a liquidity trap. 

I think that is just what has happened. The effect is actually to increase the imbalances in the global economy, making later recovery more difficult. 

In my next post in this series I will look at responses. I will also pick up the exchange rate point.

Postscript

Winton Bates wrote:" Jim, A good place to start the discussion might be with the article Noric referred to in the discussion on your previous post. I think we are dealing with a secular low investment problem rather than a Keynesian liquidity trap."

This is the article Noric referred to: "We’re in a Low-Growth World. How Did We Get Here?" I think a key point with the liquidity trap as I interpret it is that its an outcome of other things that then has its own effects. One cause is a reduced desire to invest.

On the Reserve Bank, two points flowing from discussion:

• inflation targeting is quite new
• as are formal agreements between the Reserve Bank of Australia and the Government, beginning in 1996. You will find the agreements here, the first agreement here.