red onion

Paul Krugman explains, in short terms, the liquidity trap, which is the trap the Japanese economy has fallen into, and is very difficult to climb out of. Here Paul Krugman explains the liquidity trap in long terms, if you are so inclined to read it. (Click on "economic theory" to the left on his blog, and scroll down). Basically, if I would choose one word to describe the liquidity trap, it would be deflation. However, it must be deflation following years of economic downturn, deflation out of control. Funny that in our economy, what consumers ought to be celebrating, lowered prices, deflation occurs at a time when consumers don't have the money to, consume. Very ironic, this economy.

Here is another article by Daniel Altman for the New York Times, entitled Feds Starting to Fret Over Falling Prices. I'll include this article on my site, as the NYT is difficult to access. In my view though, liquidity trap means loss of jobs for the already suffering working poor, for whom finding adequate affordable housing and health care is always, liquidity or no liquidity, a difficult challenge:

"In deciding this week to keep short-term interest rates at 1.25 percent, the Federal Reserve Board warned of "an unwelcome substantial fall in inflation." The topic also came up at its March meeting, according to minutes released yesterday. Economists have been talking about the dangers of falling prices for several months, but why did the Fed take note now?

First of all, some experts believe that the risk of deflation has increased of late. Commodity prices have been dropping for years, but now energy prices, after a spike leading up to the war in Iraq, have also slipped.

Most important, however, is the absence of an engine to drive the economy forward. With weak demand, prices could begin to fall in widespread fashion.

Ethan S. Harris, the chief economist of Lehman Brothers, puts the chance of broad deflation in the near future at about 25 percent. "You need weak economic activity for one and a half or two years" for deflation to occur, he said. "You never get the boom that's going to heal the economy."

Another concern is that the Fed is running out of leverage against deflation.

Though it took no action on Tuesday, several Wall Street banks expect it to cut short-term interest rates to 0.75 percent before July. As short-term rates edge closer to zero, expanding the money supply — the method the Fed uses for lowering rates — might have little effect on the ease of obtaining credit. Interest rates could not fall below zero, after all. Economists call this state of affairs a liquidity trap.

"It's right for the Fed to be concerned about it and talking about it," said Laurence M. Ball, a professor of economics at Johns Hopkins University. "The key thing to look at is not any particular price level, but the interest rate. When it hits zero, then you're in trouble."

Professor Ball did not predict that interest rates would fall to zero, but he warned that an unexpected shock to the economy could be more damaging with rates so low."When you're walking along the side of a cliff, the closer you are to it, the more dangerous it is," he said. "There's no particular chance you're going to fall off it, but there's always the chance you'll get jostled."

Falling prices might not sound like such a bad thing, at least from a consumer's point of view. Moreover, deflation can be a side effect of a healthy economic development, like the surges in efficiency that have steadily lowered the prices of personal computers.

But what the Fed is worried about now, the experts said, is deflation arising as a symptom of the economy's frailty. And falling prices could cause some real problems by themselves.

For example, rapid deflation can cause a huge redistribution of income and wealth from debtors to creditors, said Willem H. Buiter, a former member of the Bank of England's monetary policy committee.

When prices are expected to fall, interest rates tend to fall, too. If prices are lower tomorrow than they are today, a dollar will be worth more tomorrow in terms of what it can buy. And the more borrowers think that prices will fall in the future, the less they will be willing to pay in interest on loans. Similarly, existing loans with fixed interest rates become more valuable to lenders — and more onerous to borrowers — as prices fall.

"That kind of redistribution is often very painful because it causes all sort of distress," Mr. Buiter said, like corporate insolvencies and defaults by banks.

Deflation can also cause problems for companies with fairly inflexible costs of doing business, Mr. Harris said. "The auto industry has a pretty rigid cost structure, and obviously they'd like to see some inflation in the economy," he said. "Instead, what they're getting is they have to keep cutting the prices of their vehicles."

Mr. Harris also said expectations for deflation — if not brought on by a "productivity revolution" that makes the economy much more efficient — could themselves perpetuate economic weakness. If people think prices will fall in the future, they will postpone purchases. After two years of weakness, he said, "we already have a little element of the deflation psychology in the economy."

Some economists have also argued that falling prices for goods and services could lead to falling wages — something workers might find intolerable. But Professor Ball said there was little evidence to support that idea. "There has actually been a number of studies in the past few years looking at wages, and finding that wages do fall in certain crcumstances and there doesn't seem to be such a taboo about it."

The consequences of deflation are on display, of course, in Japan which has experienced deflation for the last three years after a decade of economic weakness. Japan's troubles began in 1990 when a huge crash in prices of real estate and securities suddenly depressed the willingness of consumers and businesses to spend. In the midst of deflation, short-term interest rates eventually fell to zero, largely handcuffing the central bank.

Well aware of Japan's striking example, the Fed's governors have been barnstorming the country in recent months to assure the public that, even with low interest rates, they still have tools to fight deflation. In a speech in December, the Fed chairman, Alan Greenspan, said the Fed could buy Treasury bonds with long maturities to drive down long-term interest rates. In January, a Fed governor, Edward M. Gramlich, said that with interest rates at zero, a rapid expansion in the money supply might still be enough to stop deflation.

But some economists have remained skeptical.

"It's probably a good thing for them to say, `Oh, don't worry, we have a lot of tools to deal with it,' " Professor Ball said. "That bolsters confidence, and is maybe good for the economy. Having said that, I'm not sure it's true that they have lots of tools. If there were any really obvious tools that the central banks could use to get you right out of a liquidity trap, Japan would have done it."

In fact, both Mr. Buiter and Professor Ball argued that in situations like Japan's, central banks should make way for the lawmakers who control taxes and spending.

"It is always both technically and politically dead easy to stop deflation and get rid of it, if you don't want it," Mr. Buiter said. "It is not necessary for these things to persist. The government should immediately prime the pump and send the checks to all deserving and undeserving Americans."

Professor Ball agreed. "The textbook solution to a liquidity trap is a fiscal expansion, and there's every reason to think that would work." In a situation of low demand and deflation, he said, "before too long, enough political pressure would build up for a big fiscal expansion."

Unfortunately for Japan, this escape plan was hard to carry out. Japan's overwhelming debt burden limited the government's ability to cut taxes or spend money. And its problems ran deeper than weak demand and deflation.

"Deflation is kind of the icing on the cake," Mr. Harris said. "The big problem in Japan is the big failure to deal with the problems in the banking system. No stimulative policy is going to work if your financial system isn't functioning — if the process of getting funds from savers to borrowers breaks down."

The United States, the experts said, is not mired in similar straits. The financial system is healthy, and, Mr. Buiter pointed out, the boom and bust in asset markets was far smaller in the United States than in Japan.

"Real estate and house prices never went on the kind of walkabout that they did in Japan," he said. "There is no parallel between what Japan has been going through for the last 10 years- plus now and what lies in store for the United States."

Professor Ball added that the government here had more latitude to fight deflation in the event of a liquidity trap. "Even though our long-term fiscal situation is not great, it's not as bad as Japan's," he said.

On that point, however, Mr. Harris was not equally sanguine. "When you get into a deflation environment and you're trying to get the economy going, there aren't any really easy solutions," he said. "Usually when you get to deflation, you already have a significant budget deficit. That's in fact true for the U.S."