Fear and the Liquidity Trap

Paul Krugman put up his analysis of liquidity traps and how he thinks they can be stopped.  I love Krugman but I think his use of expectation theory (as to how it relates to the money supply) is a little off base. Expectations about the future of the economy and expectations about future job security are what drive future spending (or cash hoarding) much more than expectations about the future of the money supply or future monetary policies.

Krugman believes the government has to fool the public into believing it's going to keep interest rates low and the money supply high almost indefinitely to avoid a liquidity trap. If sufficiently fooled he believes this will lead to spending and will stop people from hoarding cash.

I find this hard to believe.  Fear of unemployment and fear of future economic conditions are greater fears.

Economists tend to look quite a bit at the unemployment rate when calculating the severity of a recession, but the duration of an inflated unemployment rate is just as important. US Unemployment spiked to over 25% in 1932 and remained  above 14% for nearly 10 years (from 1930-1939).  Contrast that to our non-Great Depression high of just over 10% in 1982, that lasted less than two years.

An inflated unemployment rate of 10% that lasts for more than few years affects more than just 10% of the workforce.  During that time, it's not a constant 10% of the people who remain unemployed, but rather a revolving, cycle of workers gaining and losing jobs that ultimately affects a much larger portion of the population. People who have lost their jobs, fought for another one and then lost it again will have a hard time being convinced that jobs and money are future guarantees.  People who have experienced a decade long cycle of this may never be convinced again.  Which goes a long way toward explaining why Great Depression survivors hoarded cash their whole lives.

Okay, so that helps explain the Depression, but what about Japan in the 1990s and their liquidity trap?  Their recession was not nearly as deep nor as long as the Great Depression, so why the liquidity trap there?  Why did it take ten years for their people to resume spending and producing?  Well (and I admit this theory may be a bit of stretch) the Japanese are a different culture.

They're a small, tightly-knit group of islands that value honor and work above most else. Japan's population is a largely homogeneous group that holds a collective devotion to 'honor' and views the loss of a job and the loss of money, as disgraceful and dishonorable. Failure is nearly always viewed as a personal flaw in Japan as opposed to we Americans who frequently blame everyone and everything else failures.  The Japanese worker's ability to provide for his or her family in the future, and the loss of their honor if unable to do so, resulted in hoarding of cash when the country faced economic uncertainty.  There are, of course, a number of other factors and more hard and concrete evidence that the Japanese government may have flailed a bit during the years following the Asian crisis and that may have exacerbated the problem, but taken together with the Japanese mindset so fixated on honor, it seems likely that a liquidity trap couldn't be avoided.

In short, I believe the length and duration of the coming recession are what could potentially cause a liquidity trap in the United States, not misdirected fiscal policy or wrongheaded government spending.  If (as the Austrian Economists like to say) the boom leading to the collapse is sufficiently large, then the resulting recession will match it in length and depth. So if this recession is long enough and deep enough, and if consumers weren't saving enough during the boom period, then nothing will stop the recession from being deep and long. The end result could quite possibly be a universal skittishness, constant fear and a lifetime of uncertainty about the economy that will haunt the recession's survivors.

My grandparents and great grandparents are perfect evidence of this.  They lived through the Great Depression and those years affected them so deeply that they really never increase their spending for most of their lives.  They put their money in CD's, low-risk bonds and savings accounts that, most of the time, didn't beat inflation.  My American grandparents, in particular, were doing this until their recent passing just a few years ago. No amount of fiscal or monetary policy or even decade long booms convinced them of the resilience of the US economy, nor did long, sustained booms convince them that jobs and money weren't impermanent, ephemeral things.  In short, they were motivated to hoard by their fears just as the Japanese were motivated to hoard by their fears.

Let us hope this recession is not as deep and long as some fear (though Mr. Krugman himself was on CNBC last week predicting the recession and inflated unemployment would last through 2010 or perhaps 2011… yipes).

In closing, I'll leave you with a nice video of Peter Schiff, an Austrian School adherent who runs his own brokerage firm.  Mr. Schiff is seen in the video predicting the recession and collapse and debating with Felix Salmon's personal enemy, Ben Stein (who appears particularly gas-baggy in these clips) about the economy and the value of financial stocks.  Most of the people Mr. Schiff debates with laugh at him.

Oh, and lest you think I'm an Austrian School devotee myself, please realize I don't share their views about the uselessness of the Fed and government, in general.