Global liquidity trap: "the easy stuff!"

Germany sold six-month treasury bills with negative interest rate.

European banks are hoarding cash with ECB, trying desparately to manage their liquidity and balance sheets.

All these are evidence of a "liquidity trap" situation that Europe is in. By Paul Krugman's account, about 70% of the world is in the trap. The strange things going on now in Europe are just some latest evidence.

The concept is not hard to grasp, but the mainstream news media and investment community seem slow in catching on. It's nice to see Paul McCulley on CNBC today talking coordination between monetary and fiscal policies in such a world:

Idle labor, idle capital, perverse austerity

The great recession of 2008-09 has left us persistent high unemployment, record low interest rate, large corporate and bank reserves. Consumers are struggling to repair their balance sheets, yet neither governments nor large corporations are doing much to help solve the economic slump.

What's going on? Can "market" solve the problem on its own? And what do we mean by that, anyway?

The only sensible diagnosis I've seen so far by economists is that the "advanced world, accounting for 70 percent of world GDP at market prices, is in a liquidity trap."

What should be done?

In the words of Nobel Laureate Peter Diamond:

On the nation’s unemployment problem and how infrastructure spending could help solve it:

–Most of [the 9.1% unemployment rate], more than half of it, is inadequate aggregate demand and what we need now, very badly, is more fiscal stimulus and the continuation by the Fed of rolling out monetary stimulus as it fits their projections of what’s going on.

–Right now we have idle labor, idle capital… [and] interest rates are low, so doing it sooner has that advantage compared to doing it later. And third we do get a Keynesian multiplier out of it. –The fact that infrastructure spending will be phased in slowly doesn’t seem to me a shortcoming right now, because all the forecasts we’ve seen say coming out of this [malaise] is going to be a slow process.

Are we headed for another recession?

–There’s no question that we’re vulnerable….. It’s really important to put into place policies that would have the long-run effect of reducing debt growth. But there’s nothing on the debt side we need to do immediately. We do not have a debt crisis. We have a long-run debt problem and austerity today is perverse from the point of view of unemployment, and insofar as the economy is vulnerable that will make it more vulnerable, and of course a double-dip [recession] will lose us a lot of tax revenue.

Professor Diamond is known for his "search" model of labor market, which brings in a form of market friction to explain the lack of clearance in labor market. Even he thinks the unemployment problem is mostly an aggregate demand problem. The rest could perhaps be attributed to "structural" problems such as skill mismatch.

The interview with WSJ's Kelly Evans shows these takes and views:

More work to do for the Fed chief

Europe is clearly the big drag and big risk for the global economy and the market. U.S. may be the hope. President Obama's job speech last night looked like a refreshing refocus on the real thing, but he faces a difficult uphill battle to get the package through Congress.

The Fed may be able to do a bit more. Mr.Bernanke has been avoiding specifics in his last two big speeches, but provided a clear sounding board to the White House and to the Congress. The economic recovery is at risk of stalling, and the circus in Congress is making things worse.

Yet, it's troubling that Mr.Bernanke appeared troubled by "exceptionally cautious" households:

One striking aspect of the recovery is the unusual weakness in household spending. After contracting very sharply during the recession, consumer spending expanded moderately through 2010, only to decelerate in the first half of 2011. The temporary factors I mentioned earlier--the rise in commodity prices, which has hurt households' purchasing power, and the disruption in manufacturing following the Japanese disaster, which reduced auto availability and hence sales--are partial explanations for this deceleration. But households are struggling with other important headwinds as well, including the persistently high level of unemployment, slow gains in wages for those who remain employed, falling house prices, and debt burdens that remain high for many, notwithstanding that households, in the aggregate, have been saving more and borrowing less. Even taking into account the many financial pressures they face, households seem exceptionally cautious. Indeed, readings on consumer confidence have fallen substantially in recent months as people have become more pessimistic about both economic conditions and their own financial prospects.

Spending power of a typical household comes from their current income and/or their asset. If their asset is not liquid, they can borrow against it. Both sources are under heavy headwinds, as noted by the Fed chief. How much more can they do?

If Mr.Bernanke cannot get over this, and continues to hold out hope that the households will step up spending miraculously, then we're unlikely to see decisive actions from the Fed. Perhaps this is what's troubling the market.

The Fed's dual mandate

New speech from Chicago Fed President Charles Evans makes it clear why the Fed should be more aggressive in tackling the unemployment problem.

The entire article is well worth a good read. Relative to the concerns and comments from the disenting regional Fed presidents, his arguments are based both on macroeconomic theory and empirical studies.

What seems to be lacking, however, is more convincing arguments on the efficacy of un-conventional monetary policies such as QE. On this front, the article is drawing on works by Michael Woodford and perhaps Paul Krugman to argue for setting consistent policy expectations over the medium and the long run.

Ideally, the accommodative monetary policy is most effective when combined with an expansionary fiscal policy which can create final demand directly.

Higher inflation rate may be allowed by the Fed

Interesting two-part interviews with Charles Evans, Chicago Fed president. He argues that the Fed's accommodative policies have been working, and he would support further aggressive easing.





In particular he mentioned that a high level of inflation rate (say, 3% per anum) should be allowed.

He also mentioned a recent opinion piece on Financial Times by Professor Michael Woodford, a leading monetary macro economist, which focuses on setting inflationary expectations as a policy tool.

Was QE2 effective?

Slow growth and market turmoil have brought us back to QE. Markets are expecting QE3, to be telegraphed perhaps as soon as the end of August at Jackson Hole.

It's important at this juncture to ask if QE2 has been effective. Most financial commentaters have dismissed its effectiveness out of the casual observation that the economy is still not growing very much and unemployment rate is still very high. Here is an example.

John Mauldin's latest newsletter "The Beginning of the Endgame" asks the same question about QE2:

What about QE3? Let’s look at how that last move turned out. We ended up with more money on the Fed’s balance sheet and higher commodity prices. The NFIB survey I cited last week showed there was no great demand on the part of small business for loans. 91% had what they needed. What they want are sales and customers! The trade data yesterday showed exports fell by over $2.3 billion last month. That suggests a slowing world economy. Which is borne out by numerous other indicators.

Is this a fair assessment of QE2? Would one expect QE2 to create sales and customers for small businesses such that they demand for more laons? The Federal Reserve has no such power and one should not expect anything like this to start with. A fiscal stimulus may have that effect if it's designed to create final demands for these businesses. As to trade, a weaker dollar has helped. But again, the Fed can't control the world demand for U.S. goods and services. Is a slowing world economy the failure of QE2?

This type of off-hand, sloppy remarks help to cloud the general perception of monetary policies.

St Louis Fed's assessment is a good starting point. It's mostly effective, but its effect is difficult to be disentangled with the effects from other adverse shocks such as the Japanese earthquake and the European debt crisis.

One can argue perhaps QE2 wasn't large enough.

We also hear very often that normal transmission mechanisms (e.g. multiplier effect via banking system) for monetary policy have been broken, therefore QE2 or QE3 would not be effective. Paul Krugman has a different take. There are a wealth effect and a weak-dollar effect. These two effects have important investment implications.

QE is probably not the best tool to stimulate growth when the economy is weighed down by heavy debt loads. But it's probably the only viable tool to save the economy from slipping into another recession.

Fed should maintain QE and create moderate inflation

Dow dropped another 634 points today. A lot of fear in the market. This isn't because of the S&P downgrade. Investors are panicking over slowing growth or a potential contraction. Are we heading right back to recession? What can one expect from the Federal Reserve which is having a FOMC meeting tomorrow?

Ken Rogoff expressed a clear view in this interview. He thinks that the Fed should have never stopped QE2, in fact he thinks that the Fed should make it open ended and make it clear the objective is to create inflation.

Quoting Bloomberg:

Rogoff recommended the Fed say in “very clear statements” that it’s trying to create “moderate inflation.” “In the classic classroom QE, it’s open-ended,” Rogoff said. “You say, ‘I’m trying to create inflation of, let’s say 2 or 3 percent, and I’m going to do whatever it takes.’”

The Fed should also avoid repeating that officials are trying to boost stocks, Rogoff said, calling that a “bad idea.”

The Standard & Poor’s 500 Index tumbled 6.7 percent yesterday to 1,119.46 in New York trading, its biggest decline since December 2008. The benchmark Stoxx Europe 600 Index dropped 4.1 percent yesterday in London to 228.98, its biggest retreat since March 2009.

The Fed should have extended its asset-purchase program, “as controversial as it was,” instead of ending it, Rogoff said. The central bank completed the second round of bond buying in June, purchasing $600 billion of Treasuries.

“They need to move much more decisively,” Rogoff said.