It is time for the monetary authorities to jump into the liquidity trap

The (formerly) advanced industrial countries are all in or headed for the liquidity trap ‘lite’.  This is the situation where the short-term risk-free nominal interest rate cannot fall any further.  A ‘heavy’ or ‘deep’ liquidity trap occurs when nominal risk-free rates at all maturities are at their lower bound(s).

A liquidity trap ‘lite’ may occur even when short-term rates are above zero.  It will certainly occur when the short-term nominal interest rate falls to zero.  Unless the monetary authorities are willing and able to tax currency holdings, the zero nominal interest rate rate on bank notes sets a floor for all short-term nominal interest rates.  I have not seen too many central bankers perusing the works of Silvio Gesell, so for the time being, I will treat a zero short risk-free nominal interest rate as the effective floor for the risk-free nominal interest rate.

If zero is the floor, there is no reason not to go there immediately.  The recession in the US, the UK, the Eurozone, Japan and the rest of Europe is, with probability verging on certainty, going to be so deep and so prolonged, that the zero lower bound will be reached even by the most anal-retentive gradualist central bank before the middle of 2009.  So why not get it over with in December 2008 and possibly do some good in the mean time?  The required cuts in the official policy rate would be trivial in Japan (30 basis points) and in the US (100 basis points – assuming the 35 basis points penalty on bank reserves is abolished).  For the UK, a mere 300 basis points cut and for the Euro Area a 325 basis points cut would anchor the official policy rate at the floor (again assuming the 25, respectively 50, basis points reserve penalties of the Bank of England and the ECB are eliminated).

In all likelihood, cutting the central banks’ official policy rates to zero will not provide a major stimulus to financial intermediation and thus to aggregate demand.  But even if it doesn’t help,  it certainly won’t hurt.

Dr. Lorenzo Bini Smaghi, Executive Board member of the ECB disagrees.  He wants to keep some of the ECB’s interest rate powder dry.  He obviously has watched “They died with their boots on”, or some other movie of the battle of Little Big Horn in which George Armstrong Custer and his command were outgunned by the Cheyenne, the Lakota and the Arapaho.

The analogy with not firing your last bullet except in extremis is, however, not convincing (I used to believe a version of it, but have changed my mind). A cut in interest rates does not exhaust its effect on economic activity as soon as the cut is implemented.  A short-term, temporary cut has a smaller effect than a long-term, more permanent cut.  Cutting earlier means that the cumulative effect on activity at any given future date is likely to be larger.  In George Armstrong Custer terms, once you pull the trigger, the gun keeps in firing.

It is possible that there are complex psychological mechanisms (of the kind most economists and central bankers don’t understand)  that may cause an interest rate cut of a given magnitude to produce a greater cumulative effect if it is administered at just the right moment – say when an inflationary or deflationary bubble is most likely to be punctured or when fears, phobias and bandwagon effects can be influenced by some highly visible, even if largely symbolic, policy action.

While I recognise the theoretical possibility that there could be something to the ‘keeping (some of) your power dry’  argument,  I have never seen any empirical evidence that supports it, or a rigorous analytical model that lays out the precise mechanism. The argument should therefore be dismissed as a constraint on actual planned rate cuts.

Once the zero lower bound on the short nominal interest rate is reached, the arsenal of the central banks is restricted to quantitative easing – the purchase by the central bank of private and public sector securities, financed by the issuance of base money.  Such expansions of the balance sheet of the central bank can occur as a result of the collateralised lending that central banks traditionally engage in at the discount window and in repos.  It can occur through the collateralised loans extended through the ever-expanding range of special facilities created by the Fed, the Bank of England and other central banks.  Or it can occur through unsecured central bank lending or through outright purchases of private or public securities.

This process of quantitative easing can, effectively, go on forever.  It only stops when the central bank has monetised all private and public securities.  Even if the risk-free nominal interest rates at all maturities are reduced to zero (the deep liquidity trap), the scope for quantitative easing is not exhausted, because the central bank has the option of acquiring risky private securities of any and all kinds, up to and including ordinary equity.

Cutting nominal rates to zero and quantitative easing will not be inflationary as long as the virtually unbounded liquidity preference  of the private sector persists.  These measures will become inflationary as soon as normalcy returns and liquidity is, once again, just viewed as food for the faint-hearted.  At that point, there has to be a swift reversal of the quantitative easing and an increase in short nominal interest rates, sufficient to reduce the real demand for base money to a level consistent with the remaining outstanding nominal stock at the prevailing price level.  That will be a fun exercise.

My first-best scenario would be for the Fed, the ECB, the Bank of Japan and the Bank of England all to set their official policy rates at zero forthwith.  They won’t do this, regrettably.  The Bank of Japan’s interest decision really does not matter – what is 30 basis points among friends?  The Fed might as well blow what little interest rate elbow room it has left in one fell swoop.  Keeping 50 basis points in reserve for a rainy day will not impress the Cheyenne, Lakota or Arapaho.

The UK real economy is contracting quite spectacularly across the board.  The (from a parochial national British perspective) hitherto most welcome weakening of sterling is close to the point at which it ceases to be the correction of a long-standing overvaluation anomaly and begins to smell of a rout.  The most recent weakening is quite likely a reflection of the anticipation of sharp rate cuts in the near future.  That expectation can therefore be validated without risking a collapse of sterling.  I would therefore recommend a 150 basis points cut on Thursday.  This is also my expectation. The last 150 basis points cut can, if sterling does not collapse in the mean time, be saved for January 2009.

The ECB is behind the curve and in denial about the absence of a liquidity crunch in the Euro Area.  The Euro Area economy is, however, less vulnerable than the UK, because of the uniquely high indebtedness of the UK household sector and the huge size of the UK banking sector’s dodgy balance sheet relative to the size of the UK economy.  I would recommend a 125 basis points cut by the ECB next Thursday, but anticipate a mere 75.

Who said central banking was boring?

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website