Escaping the Liquidity Trap

That great sucking sound

We would have liked to title this article “Plan C”, but unfortunately The Economist thought about it first. That would have neatly summed up what policymakers have to start pondering now. As Frank Heinemann, Economic Theory Chair at the Technische Universität Berlin, points out in his latest CESifo Working Paper, the monetary authorities do not have much elbow room for lowering interest rates further in order to kick-start the economy into a revival.

Since the now iconic collapse of Lehman Brothers in September, stock prices have been tumbling at a frightening clip, but the downward trend had started much earlier. According to the IMF’s Olivier Blanchard (see article in this issue), the decline in stock market capitalisation between July 2007 and October 2008 was a whopping 7.8 trillion dollars. And that was only for the US.

So, with private investors liquidating all kinds of real-valued assets, banks selling their shares and calling in debts, and everyone looking to sovereign bonds as a safe haven, while the lower interest rates are not being passed on, we are in the midst of a credit crunch.

And, as Mr Heinemann rightly observes, monetary policy can at present neither reduce market interest rates nor stimulate the issuance of private loans, so we are stuck in a liquidity trap as well.

The problem is that in this case, the textbook solutions for escaping a liquidity crisis, namely fiscal policy or increasing inflation expectations, are unlikely to work, as the liquidity trap comes hand-in-hand with a credit crunch.

This is what explains the current downward spiral we have been observing. While there are signs that this spiral may be coming to an end, thanks to the recapitalisation of banks undertaken by governments around the world, a Plan C would be needed in case it should resume.

In theory, downward spirals end when investors take note of the depressed price of real assets and decide to re-enter the real-estate and stock markets. But usually a signal is needed to trigger them into seeing these assets as worthy of an investment.

Central banks have been working hard at sending such a signal, with their co-ordinated lowering of interest rates, but they have been fairly ineffectual thus far, as their signal did not change the relative return expectations amongst investors.

Such a signal can also be sent by high-visibility private investors. This is what Warren Buffet did, with his investment in Goldman Sachs. But, being a recapitalisation of a single bank, it failed to deliver the needed punch.

After examining possible alternatives, ranging from several large private investors co-ordinating their investments in stocks, China stepping in and using its foreign reserves to buy stocks in US markets, sovereign wealth and pension funds engaging in large-scale purchases of stocks and so on, Mr Heinemann settles for the US Federal Reserve buying up the excess supply of stocks and guaranteeing a clearly defined lower bound for the major stock indices for a limited time as the most effective measure in the present circumstances.

Such an announcement by itself should prevent further sales at fire-sale prices from occurring. By eliminating the downward risk, prices would advance significantly past the announced lower bound.

One risk would be the moral hazard that could arise from such a measure. Any such guarantee, therefore, must be temporary in nature. On the other hand, Mr Heinemann points out, inflation expectations should increase immediately after a credible announcement of such a guarantee, which would have the advantage of forestalling a dreaded deflation, thus doing its bit to help out of the liquidity trap.

A guarantee of a lower bound on stock prices, Mr Heinemann asserts, is appealing in comparison with the original Henry Paulson plan of buying toxic assets from banks, as the guarantee exploits market mechanisms for injecting equity into the banking sector. Buying troubled assets, by contrast, rewards those institutions that caused the crisis by accumulating such assets.

And the funds thus invested are not necessarily lost down a black hole. The portfolios the state would eventually have to acquire can well be sold at a profit later, when the economy returns to a healthier state.

So, if the US economy needs a Plan C, well, this one definitely sounds sensible enough. And it would be an easier sell to the public opinion than simply bailing out the institutions that caused the problem in the first place.

Frank Heinemann: Escaping from a Combination of Liquidity Trap and Credit Crunch, CESifo Working Paper No. 2450

• Other CESifo Working Papers by Frank Heinemann
• Other CESifo Working Papers dealing with liquidity
• CESifo Working Papers published in the past three months