Tuesday, July 12, 2005

Oooops It Isn't Baaack....

Morgan Stanley team members Steven Jen and Eric Chaney (joined by Takehiro Sato and David Miles) debate today the interesting question of whether the eurozone economies have entered a liquidity trap (LT). Those who have no idea what one of these would look like could do worse than read Paul Krugman's classic article on the topic: It's baaack! Japan's Slump and the Return of the Liquidity Trap (pdf).

So what is all the fuss about?

Well first of all my apologies if this is pretty sketchy, but as you probably have noticed my principal attention is elsewhere right now.

Basically the problem that is getting people scratching their heads is why the eurozone is so resillient against growth. With interest rates at a pretty low level, and monetary aggregates very generous, why isn't the thing taking off? (This is a bit like the other part of the puzzle, Bernanke's savings glut, either you get it or don't get it IMHO).

Now what do they mean by a Liquidity trap? Well the first thing to note is that they aren't referring to it in the strict technical keynesian sense (as Takehiro Sato points out). Len says he is using a loose definition of a liquidity trap in the sense that monetary easing has muted effects on domestic demand. Eric Chaney points out that this is a necessary, but not sufficient condition for having an LT:

"I see two well documented macro situations where a Keynes-type liquidity trap is emasculating monetary policy. The first one is when real interest rise independently from monetary policy because of outright deflation. The second one is when banks are not able to pass lower rates to their customers because of damaged balance sheets. This case may be reinforced by regulations such as solvency ratios. These two types are not exclusive."

Actually the damaged balance sheet issue is normally associated with the bursting of a bubble, and this may be an entry route to deflation, but it is not the only one, and it is not the defining characteristic.

Enter Krugman:

"A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero - so that injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible-price, full employment economy; and although any reasonable model of the United States in the 1930s or of Japan in the 1990s must invoke some form of price stickiness, we can think of the unemployment and output slump that occurs under such circumstances as what happens when the economy is ?trying? to have deflation - a deflationary tendency that monetary expansion is powerless to prevent."

I'll stick with Krugman's definition I think. The key point is that it proves impossible to get negative interest rates, and for this reason monetary policy is inefective, not just that monetary policy is in itself ineffective.

Now in the context of the present situation of the eurozone economies the first thing to say about all this is that there is a basic methodological problem: IMHO you just can't create an ideal type entity - the eurozone - and start talking about it in general terms in the way the MS team do. I think it's just rudimentary economics - and strangely Christian Noyer was echoing this this morning when he spoke about the structural differences between the eurozone economies in his FT interview - that you have 12 different economies with one common money. So while some of these economies may well be candidates for entering a liquidity trap in the forseeable future - Germany (were people actually reduced their credit exposure last year, and house prices are falling, and have been for some years), or Finland which is very near negative inflation, others like Ireland and Spain obviously aren't. France clearly isn't. Then you have Italy, Portugal and Greece, which don't have a liquidity trap, but have serious structural problems including BoP ones which no-one knows what to do about. So the issue doesn't arise in this way, but the problem is, in order to start thinking about the real problems, you have to break the mindset, and stop thinking eurozone, and stop thinking common monetary policy.

The Japan issue is in this sense a red herring, as Japan entered deflation and the LT following a burst bubble. This would possibly be relevant to the UK, which is not in the eurozone, and to Spain which is, should the housing bubbles turn bad. Technically this would be called (by me at least) Irving Fisher style debt deflation, and this may have been a part of Japan's problem before the demographics took over. (This issue is the 'old horse' that the MS boss - Stephen Roach - flogs tirelessly to death IMHO. A Sisyphus without smiles, the dour Sisyphus).

One last point before I turn my mind back to what is happening in the UK: the idea that increased credit creation may not be generating additional domestic demand (in Germany, as I've said this isn't true in Spain and Ireland) or the reasons why corporate spending (investment) is not taking off not being the level of interest rates, where does this take us? Not to a liquidity trap, but to a demographic trap. That is what Germany is caught in.