The Liquidity Trap: A Sticky Problem

Brad has a number of posts this week on the liquidity trap problem (and here and here . Two points occur to me: firstly, is it more than a merely semantic point whether we are 'fast approaching' or "already caught in the orbit" of one; and secondly whether (as Joerg asks me) the name is not a misnomer, wouldn't 'viscosity trap' be a better description? Meantime, John Irons recent post is as good a start for the 'unintitiated' (we still await the 'guide for the perplexed') as any you will find:

The recent FOMC statement by the Federal Reserve (Fed) included the line that "... the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level" (emphasis added.) It occurred to me that this statement might be a little confusing - isn't inflation supposed to be bad? Why would a fall in inflation be "unwelcome"? The answer has to do with what economists call a "liquidity trap." (Note: the full analysis of a liquidity trap is considerably more complicated than below, but this should convey the basic idea.)

The basic argument is that the interest elasticity of money demand increases, and monetary policy becomes less effective, when the nominal interest rate approaches zero. Ok, here's the English version...........
Source: ArgMax
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Money To Burn

Too much money, that's Andy Xie's explanation of where we are. I suspect he may be right, understanding why there may be too much money is another matter altogether.

You are holding cash and the interest rate is zero. The bank in which you keep your money pays dividends equal to 5% of the stock value. Then your friendly private banker calls you up and confidently explains that you would be better off if you owned the bank�s stock than if you continued to deposit your cash with the bank. Aha, you saw through this one! The bank�s stock price could fall but your deposits are protected, first, by the bank�s capital, i.e., shareholders, and, second, if the stock price falls to zero, by the government that regulates the bank.

We saw the same situation in the Tokyo property market. The rental yield rose above the mortgage interest rate in the 1990s. For some reason, the property value always seems to drop a bit more than the pickup in the yield for owning the property. This also happened in the Hong Kong property market. The property market was more sophisticated in Hong Kong than in Tokyo and had the affordability index to show why property was worth buying. Waves and waves of bottom-fishers braved the market. They now have no cash. However, they are proud owners of high-yield assets but at much-reduced capital values.

Asset markets have been cash guzzlers in East Asia for years. The cash goes to maintaining growth in value-subtracting GDP. Hong Kong property provides the best illustration of this point, in my view. Buyers effectively subsidize an industry that faces declining prices. Their past savings subsidize the property industry, which in turn keeps up GDP. Without the massive destruction of savings, the Hong Kong economy would have shown a much greater decline.

The stock market is a less obvious example. It can attract money through volatility. Even though most markets in Asia have been merely fluctuating for the past ten years, they have raised money to fund one industry after another. Investors have poured money into a series of growth industries. However, the high profitability of a growth industry generally proves to be ephemeral, I believe. As capacity expands, most ex-growth industries are plagued by excess capacity and low profitability.Too much money is at the root of the problem. It causes speculative spasms in asset markets and excessive capacity formation in production. The two conspire to generate high GDP growth and value destruction. Economic growth generates high profitability in an industry, only to be destroyed by easy capital for capacity formation.

The Asian experience is spreading. The world has too much money, I believe. Money with zero maturity (MZM) has grown at 12% a year in the US since the NASDAQ peaked in March 2000, 62% faster than the average for the preceding ten years. Much of the surplus liquidity in the global monetary system will be destroyed, in my view, either through (1) deflation bubbles or (2) stagflation. The world currently seems to be on the first path. The world�s asset markets are behaving increasingly like their Asian counterparts. Stock markets experience periodic speculative spikes up with little change in fundamentals. People give more and more of their savings to governments to spend. Rising fiscal deficits coincide with falling interest rates.

The relationship between markets and the economy has fundamentally changed in the current environment. Falling interest rates provide the justification for pouring more savings into low-profit activities, which keeps up GDP. Giving money to the government to spend is the ultimate expression of supporting low value-adding GDP. In a normal environment, rising profitability attracts more capital.
Source: Morgan Stanley Global Economic Forum
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Nikkei Drifts Lower as Yen Rises


The Japanese markets are drawing the logical conclusion from the weaker dollar: less exports, less profitability, weaker 'recovery' etc.

Tokyo stocks were lower in midday trade on Thursday as the shares of the country's largest exporters tumbled, after the dollar fell to a 10-month low against the yen overnight. The benchmark Nikkei 225 average was 0.7 per cent lower at 8,055.13, while the broader Topix index was down 0.5 per cent to 818.58. The dollar fell to a low of Y116 against the yen in the aftermath of the US Federal Reserve's signal about the risks of deflation. The White House reiterated that its "strong dollar" policy was unchanged but economists said market sentiment towards the currency remained weak. The dollar recovered a little ground in morning Asian trade to Y116.5 from its Y116 low, but shares of Japan's leading exporters - many of which derive the bulk of their revenues from overseas markets - were broadly lower. Sony lost 2.5 per cent to Y2,890 and Canon was down 2.7 per cent to Y4,780. Shares of Toyota, which is set to announce its annual results after the market close, were off 1.3 per cent to Y2,745. Honda was 1.7 per cent lower at Y4,040 and Nissan was 0.6 per cent lower at Y320.
Source: Financial Times
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Yen-Dollar: Japan Loses No-contest Test of Strength


Just a snippet from Reuters about yesterday's yen-dollar no-contest to illustrate what I have been saying in earlier posts.

The dollar hit a 10-month low versus the yen on Wednesday in a rapid sell-off that tested Japan's resolve to protect its vital export sector by keeping its currency weak against the greenback and the euro. "I think the fear of intervention is keeping the dollar above 116 yen at this point," said Larry Brickman, currency strategist at Bank of America in New York.In January and February, Japan's central bank intervened by selling yen for dollars, catching many investors off guard. On Wednesday traders said they could not detect intervention by Japanese authorities to stop the sharp dollar decline, which makes Japan's exports less competitive on the world market. "We do think intervention risks are significant given the pace of the dollar/yen fall," said Rebecca Patterson, global currency strategist at JP Morgan in New York. She said the lack of comments from Japanese policymakers on the yen's strength has emboldened shorter-term investors to sell the dollar. At the same time comments this week from U.S. officials supporting a strong dollar policy did little to slow the dollar sell-off, and some analysts were calling them hollow. The dollar fell as low as 116.10 yen on Wednesday before trimming its losses to trade at 116.41 yen, a loss of 0.85 percent from Tuesday's New York close. The euro was also affected by the silence surrounding the yen's strength, falling 1.66 percent against the Japanese currency to trade at 132.20 yen .
Source: Reuters News
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