Sunday, May 27, 2018

Liquidity Trap's Wild Potential To Unlease Inflation - Part 2

In a liquidity crisis, people who feel they cannot get reasonable returns on physical or normal financial investments place their assets in short-term cash bank accounts, high-risk stocks, or hoard it rather than making long-term investments. This means a high savings rate with the key issue here contained in the words, "people who feel they cannot get reasonable returns on physical or normal financial investments" get pushed in a corner. While low-interest rates are a sign of a liquidity trap they alone do not define it. Another sign is a lack of bondholders wishing to keep their bonds and investors choosing strict cash savings over bond purchasing. Still in what, and how, and where people stash their wealth does matter and it has the potential to make any recession even more severe. This has several components that sooner or later all feedback into a loop that disrupts the flow of credit and impacts the real economy. When things cross over this tipping point the return on loaning your wealth to banks, governments, and others is simply not worth the risk!

Low-Interest Rates Coupled With A Lack Of Faith
Nobody wants to loan money if they feel it most likely will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants. This is when it rapidly becomes apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward.  When this happens we are at the end game, which is the subject of the last part of this article.

Money Must Move Or A Trap Can Form
 In normal times central banks stimulate the economy by supplying and increasing the monetary base or lowering interest rates. This usually results in increased borrowing and lending, consumption, and growth in investment. When the relevant interest rate is already at or below zero lowering it to stimulate the economy losses impact. Since central banks inject new money through institutions such as banks when they do not loan it out or borrowers refuse to take new loans the capital becomes trapped. The term. "helicopter money" is often credited to Milton Friedman's suggestion that monetary authorities can bypass this trap by giving stimulus money directly to consumers or businesses. This can be done in several ways such as a tax cut or directed through programs like "cash for clunkers" that target and bolster a weak sector of the economy.

John Maynard Keynes, 1883 – 1946, a British economist, is usually considered the father of the liquidity-trap theory. It was his view that when financial speculators begin to fear the possibility of losing capital losses on non-money assets they would turn to holding money instead because it is far more liquid. This type of situation tends to develop after a financial crisis such as that associated with the Stock Market Crash of 1929 which resulted in the Great Depression. In such a situation if interest rates are extremely low and there is no place for bond yields to go but up locking in rates by purchasing bonds only creates future loses for investors. At this point, further injections of cash into the private banking system by a central bank will fail to decrease interest rates making monetary policy ineffective.

 Printing Money Has Not Solved Japan'sProblem
A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Japan is often viewed as the poster child for liquidity traps because as a result of the country's economic bubble having burst it has suffered for decades. Since its crash, Japan has been struggling with persistent deflation and slow growth. The Nikkei sat at 7,054 in 2009, down more than 80% from its peak., even today it is still far below the all-time high it set in December 1989. Today even after several periods of booms that went busts, the powerful combination of Abenomics, Draghi's bazooka, the Federal Reserve pouring out trillions of dollars in excess liquidity Japan's economy has failed to bring Japan out of its funk.

While the Japanese story has led some people to believe that simply expanding the central bank’s balance sheet isn't inflationary it does not tell the whole story. The world economy has a huge number of moving parts and I contend the primary reason that inflation has not raised its ugly head to become a major economic issue is that we as a society are pouring such a large percentage of our wealth into intangible products or goods including currencies. If faith drops in these intangible "promises" and money would suddenly rush into tangible goods seeking a safe haven inflation will soar. So much money has been created over the last decade that the flight to tangibles would not only spike the cost of living but leave the poor and unprotected in dire straits.

The policy of rapid credit expansion often brings with it negative consequences. China is an example of this, there we have witnessed the extra GDP growth generated by each infusion of money drop. This should be taken as a warning that economic exhaustion and overcapacity results from continually priming the pump. The total credit in China's financial system is estimated to be as high as  221% of GDP and has jumped almost eight-fold over the last decade. This means companies will have to pay out $1 trillion in interest payments this year. Chinese corporate debt burdens are much higher than those of other economies. Much of the new money that is being created to keep liquidity in the system is being used to repay debt rather than to finance output. The fact that new investment in factories has ground to a halt is probably a good thing because China is awash in overcapacity with many new factories idle because of weak demand. This has resulted in a large-scale capital outflow of hot money from China that has disrupted markets across the world.

Several things can get the economy out of a liquidity trap such as raising interest rates which encourages people to invest and save their cash, instead of hoarding it also encourages banks to lend since they'll get a higher return. This also increases the velocity of money simply put, the future reward has to become greater than the risk. As prices fall to such a low point that people just can't resist shopping they will buy both durable goods and assets like stocks. An increase in government spending can also create confidence that the nation's leaders will support economic growth. It also directly creates jobs, reducing unemployment and hoarding. Even financial innovation helps an economy escape the trap by creating entirely new markets and new places to invest.

Still, the bottom-line remains, why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? This means rejecting bonds that pay little, nothing, or have a negative rate. We have abused the large amount of wiggle room in our economic system and only proved "those in power will put off the day of reckoning until they can't!" Unfortunately, collecting a debt that you are owed can be similar to a mirage that keeps moving away each time you approach it. Also, do not forget the small print that governs most contracts often tells us rules can be changed which means people and companies can become instantly insolvent. Modern society has become very good at kicking the can down the road and delaying the consequences of bad policy but at some point, the return on loaning wealth in the form of money is simply not worth the risk!

Readers of my blog will be familiar with this argument and my strong warning that when the only lenders are those who print the money that nobody wants the only safe place to store wealth will be in "tangible assets." This fear could unleash inflation across the glode. While a liquidity trap can and often does lead to no growth and deflation it is not a certainty. The wild card, in my opinion, is related to the diminished confidence so many people have towards fiat currency. Again I want to point out that never before has the world seen so much wealth held in some form of paper promises and IOUs. This means that two key areas to watch in the future are currency markets and relevant value rather than inflation or deflation. A lack of confidence in currencies has grown over the years since President Nixon cut the link between gold and the dollar which tied the dollar's value to tangible assets that is why as we print more and more it has become worth less and less.

Footnote; This is part two of a two-part series. Part one explores how a "liquidity trap" differs from the standard liquidity problem where money is just expensive or unavailable. In many ways a liquidity trap it is just the opposite. This causes a great deal of confusion and can be a difficult concept to comprehend. The link below takes you to part one that looks at the ramifications flowing from each as they play out and how they affect the economy.

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