Wednesday, August 31, 2011

FOMC | Krugman and the Liquidity Trap

On December 18, 2008, I reported on a speech by Laurence Meyer of Macroeconomic Advisors in which he said that after the December 16 Federal Open Market Committee statement, the FOMC could go on vacation for two years. In other words, by going to the zero (actually 0-0.25 percent) interest rate policy, the Fed was out of ammunition in the battle for recovery from the financial meltdown. In other words, the United States was in the Japanese liquidity trap.

Paul Krugman wrote an article in 1998 for Brookings with two other economists on the Japanese liquidity trap. In 1999 he posted his prescient thoughts about the possibility of a Japanese-style liquidity trap happening in the United States. He reviewed the assumptions of the traditional IS-LM model and concluded that at the zero-interest bound characteristic of the liquidity trap, the central bank has little power. In order to change expectations, he argues that inflation targeting is the solution - the central bank should plan on a certain degree of significant inflation. That will impose a negative interest rate on passive owners of liquid assets. It will force them to hunt for yield higher than the inflation rate and - assuming the banking system is working properly (which it was not doing in the first decade of this century) - that will prompt owners of liquid assets to invest. Krugman posted again on the liquidity trap in 2010 but with no mention of inflation targeting.

Interestingly, the 12th edition of Baumol and Blinder, Economics: Principles and Policy (South-Western, 2012, 2011) does not include anything specific about the IS-LM model. (Co-author Alan Blinder was formerly Vice Chairman of the Federal Reserve Board.)  The book does not include "zero-interest" or "zero bound" or "liquidity trap" in its index. But it does have  a box on inflation targeting (p. 695), noting that the current Fed Chairman, Ben Bernanke, was a "big advocate" of inflation when he was a Princeton professor. The British Chancellor of the Exchequer sets an inflation target (currently 2 percent) and the Bank of England is required to work towards meeting that target. Stanford Professor John Taylor showed during the Chairmanship of Alan Greenspan that the Fed's decisions could be replicated with a simple guideline, the "Taylor Rule": (1) When the inflation rate is above 2 percent, raise the real interest rate proportionately above 2 percent. (2) When there is a recessionary gap, reduce the real interest rate below 2 percent proportionate to the recession. Baumol and Blinder note that "No central bank uses the Taylor rule as a mechanical rule." But it is a useful guide to what is actually going on.