What a difference a “Liquidity Trap” makes

This 2003 article from Krugman – “Don´t look down” – is interesting:

During the 1990′s I spent much of my time focusing on economic crises around the world — in particular, on currency crises like those that struck Southeast Asia in 1997 and Argentina in 2001. The timing of such crises is hard to predict. But there are warning signs, like big trade and budget deficits and rising debt burdens.

And there’s one thing I can’t help noticing: a third world country with America’s recent numbers — its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world — would definitely be on the watch list.

I’m not the only one thinking that. Lehman Brothers has a mathematical model known as Damocles that it calls ”an early warning system to identify the likelihood of countries entering into financial crises.” Developing nations are looking pretty safe these days. But applying the same model to some advanced countries ”would set Damocles’ alarm bells ringing.” Lehman’s press release adds, ”Most conspicuous of these threats is the United States.”

Still, there’s no question that the U.S. has the resources to climb out of its financial hole. The question is whether it has the political will.

There is now a huge structural gap — that is, a gap that won’t go away even if the economy recovers — between U.S. spending and revenue. For the time being, borrowing can fill that gap. But eventually there must be either a large tax increase or major cuts in popular programs. If our political system can’t bring itself to choose one alternative or the other — and so far the commander in chief refuses even to admit that we have a problem — we will eventually face a nasty financial crisis.

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

I know: it all sounds unbelievable. But would you have believed, three years ago, that the U.S. budget would plunge so quickly from a record surplus to a record deficit? And would you have believed that, confronted with that plunge, our leaders would offer excuses rather than solutions?

The big irony is the Lehman developed financial crises seer “Damocles”! Pity it never bothered looking “inward”.

And back in 2003 the “Wile E. Coyote” moment didn´t materialize. Over the next three years the budget reversed to the tune of 2.8% of GDP. But then, in early 2008 the W.E.C. moment arrived, and as in the cartoon the budget (and aggregate demand) plunged.

But the “plunge” looked very different from what Krugman imagined. There was no sharp fall in the dollar and, contrary to his expectation, interest rates dropped sharply. And the government´s access to borrowing has not been cut off, quite the opposite actually. So that´s not the reason for the economic chaos the gripped the nation. Actually it may not be farfetched to associate much of the plunge in the budget to the plunge in aggregate demand (and that´s the Fed´s responsibility).

But how come that now, with a much larger budget deficit (and much higher debt) than in 2003, Krugman proposes further increases? According to him what changes everything is the presence, today, of a “liquidity trap”.

But note the inconsistency. Krugman is the first to recognize that the “liquidity trap” exists only because the Fed cannot commit to being “irresponsible”, i.e. let inflation expectations go up. But his advocacy for further deficits today rests on the premise that the government can credibly commit to being “responsible” in the future, i.e. increase taxes and reduce expenditures after the storm has calmed. Since he´s fond of picking on the “confidence fairy”, I would call that the “commitment fairy”!

Choose your preferred fairy tale.

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4 thoughts on “What a difference a “Liquidity Trap” makes

  1. Pingback: TheMoneyIllusion » It’s not austerity vs. big government

  2. “Choose your preferred fairy tale.”

    At least Krugman’s fairy tale isn’t as gruesome as the German fairy tale.

    In the German fairy tale, the witch (Angela Merkel) eats Hansel and Gretel (50% youth unemployment.

  3. Pingback: It’s not austerity vs. big government-Economic News | Coffee At Joe's

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