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The Liquidity Trap

from John Mauldin’s Thoughts from the Frontline

Central banks have proven that they can make money cheap and plentiful, but the money they’ve created isn’t moving around the economy or stimulating demand. It’s like a car. Our central banker can put the pedal to the metal and flood the engine with gas; but because the transmission is busted, it’s hard to shift gears, and power isn’t delivered to the wheels. Without a transmission mechanism, monetary policy is ineffective. Study after study has shown that quantitative easing didn’t produce the “bang for the buck” that central bankers hoped it would. After a credit crisis like last decade’s, central bankers can cut the nominal interest rate all the way to zero and still not be able to get their economies in gear. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’s original meaning).

The Great Recession plunged us into a liquidity trap the likes of which the world hadn’t seen since the Great Depression, although Japan has been more or less mired in a liquidity trap since their bubble burst in 1989.

Economists who study liquidity traps know that some of the usual rules of economics don’t apply when an economy is stuck in one. Large budget deficits don’t drive up interest rates; printing money isn’t inflationary; and cutting government spending has an exaggerated impact on the economy.

HKO

Monetary policy has been the savior of bad fiscal policy. With zero interest rates the Fed’s ability to bailout wrongheaded government decisions has been neutered.  We have given them a gun, but denied them ammo.

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