Monday, June 25, 2012

What Krugman Said

It's taken me a very long time to get my head around the idea of the "liquidity trap" -- and frankly, I'm not sure I still get the idea completely.  However, this is a very lucid explanation of what's involved from Krugman:

Now, if people are borrowing, other people must be lending. What induced the necessary lending? Higher real interest rates, which encouraged “patient” economic agents to spend less than their incomes while the impatient spent more.

OK, so that’s what happens when an economy is engaged in increased leveraging. Then something makes people remember the dangers of debt, and leveraging gives way to deleveraging.

You might think that the process would be symmetric: debtors pay down their debt, while creditors are correspondingly induced to spend more by low real interest rates. And it would be symmetric if the shock were small enough. In fact, however, the deleveraging shock has been so large that we’re hard up against the zero lower bound; interest rates can’t go low enough. And so we have a persistent excess of desired saving over desired investment, which is to say persistently inadequate demand, which is to say a depression.

By the way, this is in a fundamental sense a market failure: there is a price mechanism, the real interest rate, that because of the zero lower bound can’t do its job under certain circumstances, namely the circumstances we face now.
What to do? One answer is fiscal policy: let governments temporarily run big enough deficits to maintain more or less full employment, while the private sector repairs its balance sheets. The other answer is unconventional monetary policy to get around the problem of the zero lower bound: maybe unconventional asset purchases, but the obvious answer is to try to create expected inflation, so as to reduce real rates.

Now look at what the serious people say: we must have fiscal austerity, not stimulus, because debt is bad; we must not have unconventional monetary policy, because that would endanger “credibility” (where it’s not at all clear what that means).

So basically, we must do nothing to fix this horrific market failure, and allow unemployment to fester instead.

It’s really awesome, when you think about — not just that we’re committing this massive act of folly, but that it’s all being done in the name of sound policy.

This is one of the reasons I harp on the lower levels levels of monetary velocity right now; that tells us people simply are not spending nearly as fast as they should.  As a result, money is being "saved" -- or perhaps more appropriately, not spent.  As a result, there is an excess of funds to lend.  But, there is not enough investment to soak up the increased savings.  In theory, this would be accomplished by lower interest rates -- which, unfortunately, can't go lower than 0%.  This means there's essentially a market failure in the money market -- interest rates can't move lower.  Hence, we see a primary reason for the low interest rates on government debt; we have an excess of savings sopping them up.  This also tells us that government bonds aren't competing with corporates for financing.