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Wednesday, October 8, 2008

Real Liquidity Trap

The Fed just announced a 1/2 point interest rate cut to try to stimulate the economy and provide funds for investment.  This to me may be more harmful than helpful.  As economists like Paul Krugman have pointed out, we are close to a Keynesian liquidity trap - where nominal interest rates approach zero meaning that with each successive cut, the effect of monetary policy on the economy approaches zero.  

But the real problem is one of coordination failure cause by bad debt and lack of confidence in our financial system.  That is what is causing the crisis.  Throwing more money at the problem and driving real interest rates further down has the effect of causing a REAL liquidity trap, which is increasing the incentive to hoard.  In times of financial crisis, people take money out of risky assets and want to put it in less risky ones.  But the real yields on these assets become lower and may become negative as the Fed cuts rates.  This increases the incentive to take money out of the system, to hoard it, to keep cash on hand, and to use it to pay down past spending (debt accumulated from past credit).   So, is this really the best policy to stimulate our economy and provide liquidity?  It seems it could have the opposite effect!

What are our options?  Maybe direct government outlays?  Direct spending?  But then doesn't that just exacerbate our real long term problems with spending more money than we have?  Maybe we have to feel this pain for a while.  

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