This posting responds to a lively and insightful commentary on my Column (February 15, 2010) on Paul Krugman and the liquidity trap. Let me start by outlining some relevant statistics.
1. The debt overhang: Since Irving Fisher’s famous 1933 paper, it has been well known that high and rising levels of debt in an economy impact adversely on economic growth. In the third quarter of 2009, the total amount of debt in the United States (private as well as public) amounted to $3.70 for every dollar of gross domestic product (370 per cent). This reflects an exponential rate of growth from $1.60 per dollar of gross domestic product (160 per cent) in 1980. The growth rate accelerated dramatically from 2001 under the administrations of George W. Bush and Barack Obama.
2. The expansion of high-powered money: Since Irving Fisher’s famous 1911 paper, it has been suspected that a significant increase in the quantity of high-powered money will generate price inflation within an economy. Since September 2008, the Federal Reserve has engaged in a massive expansion of Federal Reserve Bank credit from $1 trillion to $2.2 trillion. Under normal circumstances, the money supply (M2) might well have expanded to this increase in reserves by $4 trillion, or 96 per cent, triggering an extremely high rate of price inflation. Milton Friedman’s research certainly would predict such a response. Many economists, myself included, expect a significant hike in the inflation rate unless, somehow, the Fed can stem the impact of excess bank reserves. This expectation can be seen in the rising price of gold on world markets. As yet, however, the link between an increase in M and an increase in P has not manifested itself.
3. The stagnation of M2: The money supply (M2) has manifestly failed to increase at a rate consistent with the monetarist model. Instead, through 2009, M2 rose only 3 per cent, less than one half its average growth rate over the previous 50 years. If as Friedman assumed, the income velocity of circulation of money is stable (MV=GDP) then nominal GDP expansion through 2010 can be expected to grow at approximately 3 per cent. With the inflation rate hovering around 1.5 per cent, the real rate of growth of GDP would also hover around 1.5 per cent, way below the level necessary to restore the US economy to anything approaching full employment. In fact, during the last two quarters of 2009, the growth rate of M2 slowed to zero. This implies that, by early 2011, the growth rate of GDP in the United States will fall to zero, with no change in the price level (Hoisington. Quarterly Review and Outlook, Fourth Quarter 2009).
What has happened?
Let me outline two alternative theories that attempt to explain this unusual phenomenon. The first relies upon the debt overhang statistic and the associated fear of price deflation. In their 2009 book – This Time is Different-Eight Centuries of Financial Folly – Reinhart and Rogoff analyze the role of debt in creating financial crises in 66 countries over a period of 800 years. They demonstrate that the principal factor that explains more than 250 crises was excessive debt relative to national income. They conclude that this time is no different, that excessive debt has led to major economic contraction and deflation as individuals and governments seek to pay down their debts. If this theory indeed is accurate, then the deficit spending by Bush and , especially, by Obama, in the United States and by Gordon Brown in the United Kingdom, is simply disastrous, prolonging and deepening the deflationary phase. Just as in the case of Hoover and FDR, presidential policies turn a limited recession into a Great Depression. Under this theory, the banks do not lend because there are few customers for fixed interest loans in a climate of pessimistic, deflationary expectations.
The second explanation focuses attention on the relationship between the Federal Reserve and the banks, upon monetary rather than fiscal policy, and suggests that flooding the system with excess liquidity has been a serious mistake of policy. The policy error, it is suggested, occurred because the Fed wrongly focused on the shortfall in aggregate demand rather than on the underlying supply constraint of credit availability (Ronald McKinnon, ‘Why Banks Aren’t Lending’, The International Economy , Fall 2009). By driving short term interest rates down to zero, the Fed provided incentives for risk-averse banks to borrow virtually for nothing and to invest in low yield Treasury notes, rather than running the risk of a repeat of September 2008, by purchasing higher- risk assets. The solution to this credit rationing, McKinnon argues, is to elevate very short term borrowing rates on the banks, without disturbing (much) longer-term rates on Treasury notes, thus forcing profit-seeking banks to invest in riskier waters, thereby expanding M2 in the usual manner.
In my judgment, both theories are relevant. For Ben Bernanke, they combine to bring to the fore his worst nightmare. If he jacks up short-term rates, and forces the banks to lend, up jumps the money multiplier and, with it, the risk of inflation. If he reverses course and pays the banks not to lend, then he generates price deflation. Bad luck, Bad Ben!
Now if only he could mop up the excess reserves while forcing the banks to lend, he would be in Monetary Paradise. But, for Bad Ben, Monetary Paradise is Lost. His balance sheet is highly leveraged, saddled with toxic assets rather than Treasury notes. Like Old Mother Hubbard, his cupboard is all but bare. He cannot give his presidential dog its much needed bone.