It’s a Trap!

by Benjamin Studebaker

In the rush to come up with a plan of spending cuts and tax hikes, both democrats and republicans have missed the essential detail that makes our current economic circumstances different from any we have previously experienced since World War II–it’s a trap. A liquidity trap, that is, and it’s going to make any spending cuts and tax hikes the US government enacts mean serious pain for millions of people.

What is a liquidity trap? A liquidity trap occurs when the Federal Reserve has already played all of its traditional monetary policy cards–with interest rates sitting at zero, the Federal Reserve can drop them no further to encourage growth, and so fiscal policy, the amount the governments spends, becomes the dominant variable. In normal times, if the government wants to reduce spending, it can offset any negative impact on growth by reducing the interest rate or keeping it steady when it otherwise would have needed to raise it. During a liquidity trap, there is nowhere lower for the interest rate to go, so spending cuts directly lead to unemployment and reduced growth. So how do we know that we are in such a trap right now? The interest rate is sitting at zero:

The interest rate can go no lower than just above 0%, where it presently sits, and this means that there can be no expansionary adjustment via monetary policy to make up for a contractionary fiscal policy. None of this would be a problem if the economy were presently experiencing strong growth and near full employment, but neither of those are the case–growth remains about a point per quarter below its nineties average, and unemployment is far from negligible at 7.9%.

So what happens when the government passes spending cuts and tax hikes? The people who receive money from the government will have less to spend, and the people who pay taxes to the government will have less to spend. In short, everyone will have less money, so everyone spends less money. When everyone spends less money, everyone makes less money. The economic system only functions properly when money is flowing through the system from person to person. A reduced rate of flow means reduced economic efficiency and an inability on the part of the economic system to raise the money necessary to sustain so many people in employment. The unemployment figure will rise and growth will slow.

Last I checked, we were not satisfied with our present growth rate or with our high rate of unemployment, so it seems a rather foolish thing to do something right this moment that will make both of those problems worse. Perhaps I am forgetting the United States’ large amount of debt? Perhaps that’s a more important problem than all of this? The thing about debt is that it is only a problem if you cannot borrow money at a low rate of interest. So long as the government can borrow money cheaply, inflation eats away at the value of the debt and the government can continue to borrow more or less indefinitely. Currently, US borrowing costs remain shockingly cheap–while many European countries are experiencing interest rates on their bonds near or over the 7% danger zone, US borrowing costs have been consistently cheap for a while now:

The inflation rate is has been higher than the interest rate on the bonds for most of the last year, which means the money is being borrowed at a negative real interest rate–investors are paying the US government to have their money:

So what is the government so worried about? Why are we playing games with debt and talking about spending cuts when the unemployment rate is just under 8% and the growth rate is still sluggish? The deficit hawks who advise austerity have been making two predictions since Obama passed the stimulus package in 2009:

  1. The rate of inflation will skyrocket.
  2. US borrowing costs will soar.

You can see the graphs for inflation and borrowing costs above. The inflation rate is sitting around a very pleasant 2%, borrowing costs are even lower, there’s no sign of this deficit or this debt causing our economy any problems at all right now whatsoever. The predictions made by those who theorised that there would be some have been consistently wrong over the last four years. The predictions made by Krugman, DeLong, and the other Keynesians have been consistently correct:

  1. Borrowing costs would remain low so long as the economy remained weak.
  2. The rate of inflation would remain low so long as the economy remained weak.

The policies advocated by these economists fly in the face of what the government is presently trying to do–stimulus to drive unemployment down a couple more percentage points, lift growth considerably, and escape the trap. Then, and only then, when the Federal Reserve is preparing to raise the interest rates to prevent the economy from going into overdrive, does austerity become a feasible policy without creating tremendous harm throughout the economy. Until then, the policies being pursued by this president and this congress serve only to risk flinging us back into the trap, with low growth (or even, in extreme cases, a new recession) and higher unemployment that would wipe out all the gains made in reducing the unemployment rate over the last four years.

Why throw away what we have managed to achieve, limited though it is, over the last four years to reduce a deficit that is not at present an urgent concern? I have been reading macroeconomics much more intensively over the last several years than I did in the past, and I have yet to see a good reason for doing so. The United Kingdom, a country which was in a situation quite similar to the one in which the United States finds itself in 2010, chose to do austerity. Here’s what happened to them:

A rate of unemployment that jumps back over 8% and stays there for two years and a GDP growth rate that goes stagnant and then hits a double dip recession for most of a year. Is that what we want? Obviously not. So why are we doing it? The only explanation I can think of is just unbridled ignorance in both the legislative and executive branches of the very concept of the liquidity trap and what it means for policy. Of course, if Krugman, DeLong, and others with their vast audiences cannot convince anyone in the government of the economic realities, I have no idea why I even imagine it worth trying. And yet, here we are.