Liquidity Traps, Money, Inflation, and Bond Yields

Stephen Williamson:

What is a liquidity trap? This is really two questions: (i) What is the "liquidity" that is getting trapped and (ii) What is the "trap" all about? In Old Keynesian economics and Old Monetarism, we think of the financial world in terms of two assets: interest-bearing assets and money. Money is the stuff that is used in transactions - liquidity - and private sector economic agents are willing to substitute money for interest-bearing assets in response to changes in the nominal interest rate. The nominal interest rate is essentially a measure of the scarcity of money as a medium of exchange. Monetary policy is about swaps by the central bank of money for interest bearing assets, or the reverse, and the attendant effects of those actions. One of those effects is a short-run liquidity effect. A central bank swap of money for interest bearing assets tends to make money less scarce as a medium of exchange in the short run, and the nominal interest rate falls.

But what if the nominal interest rate were zero? In that case, money is not scarce as a medium of exchange, so that money and "interest-bearing" assets are essentially identical, in which case central bank swaps of money for other assets are irrelevant. That's Grandma's liquidity trap. ...

If there are many policies that support a zero nominal interest rate forever, that's also saying that there is a subset of monetary policies, among which the choice is irrelevant, i.e. if the central bank conducts certain kinds of asset swaps, then nothing changes, i.e. there is a liquidity trap.

Why am I calling this Grandma's liquidity trap? During the National Banking era, there were recurrent banking panic episodes, and it is most useful to think of these as currency shortages, i.e. "liquidity" shortages. The way to correct a currency shortage is through conventional central bank actions - open market purchases of interest-bearing assets and discount window lending. This is just the logical extension of standard day-to-day central banking practice: Target a "degree of liquidity scarcity," i.e. a nominal interest rate, and then accommodate shocks to the private sector's demand for liquidity. This view of the world is consistent with how Friedman and Schwartz thought about the Great Depression. Basically, in Grandma's world, the idea is that the central bank does not need to be worried about the sources of fluctuations in the demand for currency. All that matters is that these fluctuations be accommodated appropriately with the standard tools available to central bankers.

I am convinced that this is not the way we want to think about the recent financial crisis, or about how monetary policy should be conducted given current circumstances. We are not in Grandma's liquidity trap.

Here's a better way to think about it. Think of the world as having two kinds of liquidity: currency and other liquid assets. The other liquid assets include bank reserves, Treasury bills, long maturity government debt, asset-backed securities, bank loans, etc. - all the assets that are somehow useful in some form of exchange (retail, wholesale, financial) either directly, or because they can be transformed by financial intermediaries into some asset that can be used in exchange. The "other liquid assets" of course have different characteristics, and are used in different ways in exchange. Risk, including maturity risk, is important in determining the prices of these assets (relative to each other), and different liquid assets will have different liquidity properties, reflected in how they are used in exchange. An important concept here is the "liquidity premium" which we can measure as the difference between an asset's market price, and its "fundamental," i.e. the price it would trade at, based on the stream of future payoffs the asset is a claim to, if the asset were not useful in exchange.

Bank reserves - the accounts of financial institutions with the Fed - are a key liquid asset, as reserves are used daily in the clearing and settlement of a very large volume of transactions. However, it takes a very small quantity of reserves to support this extremely large volume of financial trade - the velocity of circulation of reserves within a day (pre-financial crisis) is typically humongous. Currently, the financial system is awash with reserves, to the point where the marginal value of reserves in financial transactions is essentially zero. The interest rate on reserves (IROR), which is currently 0.25%, is higher than the interest rate on 3-month T-bills, which is currently 0%. Thus, T-bills command a higher liquidity premium than do reserves, as they are actually more useful in financial exchange (inside and outside the US).

The key liquidity trap - the contemporary liquidity trap - the Fed is faced with currently is that all of the other liquid assets are now essentially identical, from the point of view of Fed asset swaps. The Fed cannot make reserves more or less scarce as a liquid asset through swaps of reserves for other assets, and therefore has no hope of moving asset prices. The Fed can swap reserves for T-bills or reserves for long-maturity Treasuries all it wants, but because this essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect.

An important point to note is that the contemporary liquidity trap, in contrast to Grandma's liquidity trap, has nothing to do with the zero lower bound on the nominal interest rate. Remember that the short-term safe nominal interest rate tells you how scarce currency is relative to other liquid assets. The IROR could be 2%, 5%, or 8%, so that currency is scarce, but there would still be a contemporary liquidity trap if reserves were not scarce relative to other liquid assets.

As I have discussed in earlier posts, the only relevant policy instrument the Fed has, so long as the stock of excess reserves is positive, is the IROR. Thus, the only lever the Fed has is the ability to make currency more or less scarce relative to other liquid assets, and that is the avenue by which the Fed can control the prices of goods and services. Here is where the zero lower bound on the IROR comes in of course. At the zero lower bound, the Fed cannot achieve a higher price level, except through talk about the future.

Now, to put this in context, let's look at some traditional monetary measures.The first chart shows the stock of currency over the last five years. You can see that the currency supply grew significantly during the financial crisis; this is likely driven by overseas demand, but it is hard to know - we don't know exactly where US currency resides or what it is doing. Over the last two years, and particularly this year, currency has been growing at a reasonably brisk pace (more on growth rates later).

The key thing to note here is that, under the current regime (positive stock of excess reserves), the currency stock is not directly under the Fed's control. The Fed determines the total stock of outside money (currency + reserves) and financial institutions, firms, and consumers determine how that is split between currency and reserves. The stock of currency could be rising because the demand for it is rising, or because reserves are looking less desirable for financial institutions. This of course matters - in the latter case this would be inflationary, in the former case not.

The next two charts show M1 and M2, again for the last 5 years.These charts are very interesting. Both M1 and M2 show recent large spikes. Further, if we look at year-over-year growth rates in currency, M1, and M2, these are all getting large, as we see in the next chart. The twelve-month growth rate in M1 now exceeds 20%, and growth rates in M2 and currency are at or close to 10%. Allan Meltzer should be having a cow.

Of course, this is where Grandma's liquidity trap comes in. Monetary aggregates are constructed to include private and public liabilities that are widely used in exchange by firms and consumers, under "normal" circumstances. But circumstances are not normal - a checking account is now a convenient short-term store of value with no associated opportunity cost. Thus, these spikes in M1 and M2 need not be associated with more inflation. However, I don't think we know enough to tell.

But why the spikes in M1 and M2 in the last weeks? That may have something to do with what you see in the last chart. This one shows, again for the last five years, nominal and real (i.e. TIPS) yields on 10-year Treasuries. These yields have also fallen significantly in the last weeks. This reflects a scarcity of other liquid assets, presumably because of a general "flight to quality" in world asset markets.

Now, if other liquid assets are becoming more scarce, it would make sense that we should see growth in financial intermediation, reflected in growth in M1 and M2, as the private sector creates more assets in the "other liquid assets" category. However, it could also be that there has been a decrease in financial intermediation not reflected in M1 and M2. For example, there could have been a shift out of "shadow banking" into conventional commercial banking, but unfortunately we do not measure shadow banking activity.

The scarcity we are observing is not a traditional currency scarcity. As such, we can't correct the scarcity by using conventional central banking tools - open market operations in short-term government debt and discount window lending. Neither can we correct it through "quantitative easing." We cannot ease anything through swaps of reserves for long-maturity debt, as that cannot make reserves relatively less scarce under the current circumstances. But the inability of monetary policy to correct the liquidity scarcity problem has nothing to do with the zero lower bound on short-term nominal interest rates, as the key problem is a contemporary liquidity trap, not Grandma's liquidity trap.

How can government action mitigate the liquidity scarcity? If monetary policy cannot do it, that leaves fiscal policy. But there is a tendency, particularly in the blogosphere, to frame the problem in Old Keynesian terms. In this view, we are facing Grandma's liquidity trap, the LM curve is flat, monetary policy doesn't work, so shift the IS curve instead. Further, unemployment is very high and persistent, so it might seem natural to have the government employ people directly by spending more. But the problem here is financial, and it's not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia.

One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.

What's the difficulty here? Well, the US government apparently has a very difficult time making decisions on fiscal matters, and seems not to like commitment, so what I am proposing is just not feasible politically. You might think it convenient if the Fed could conduct limited types of fiscal policy, but that requires giving the power to tax to unelected officials, and that seems a bad idea.

So where does that leave us? The key financial problem facing us is a scarcity of other liquid assets, not a traditional currency scarcity. The Fed is powerless to solve that problem; the Treasury could in principle solve it but cannot. For now, the Fed can only monitor the economy for signs of a more serious inflation. Some of those signs may already be there, for example in currency growth, though it is hard to tell what is driving that.