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Tuesday, September 17, 2013

Escaping liquidity traps

A "liquidity trap" is where interest rates are zero, and so cannot be reduced any further, even if that is necessary to stimulate growth.   In most developed countries, the cash (discount) rate is at or very close to zero.  Stimulating growth requires further monetary stimulus, and the current technique is called QE (quantitative easing) where the central bank buys long-dated government stock to drive down long term interest rates.  But that hasn't been very effective.

The last time we had a liquidity trap on the scale we now do was during the great depression.  In this article, Nicholas Crafts shows how the government stimulated the British economy using unconventional measures.

In mid-1932, the UK had experienced a recession of a similar magnitude to that of 2008-09, was engaged in fiscal consolidation that reduced the structural budget deficit by about 4% of GDP, had short-term interest rates that were close to zero, and was in a double-dip recession (Crafts and Fearon 2013). The years from 1933 through 1936 saw a very strong recovery with growth of over 4% in every year. The Chancellor of the Exchequer, Neville Chamberlain (in office from November 1931 to May 1937) was the architect of this recovery. 

The policy framework adopted from mid-1932 has a strong resemblance to the so-called ‘foolproof way’ of escaping from the liquidity trap (Svensson, 2003) and to ‘Abenomics’ in today’s Japan:
  • After the forced exit from the gold standard in September 1931, by the middle of 1932 the Treasury had devised the so-called ‘cheap-money policy’.
Initially, short-term interest rates were cut to around 0.6% – and stayed there throughout the rest of the decade (see Table 1).
  • Second, a price-level target was announced by Chamberlain in July 1932 which aimed to end price deflation and return prices to the 1929 level.
  • Third, the Treasury adopted a policy of exchange-rate targets that entailed a large devaluation first pegging the pound against the dollar at 3.40 and then against the French franc at 77 (Howson 1980), intervening in the market through the Exchange Equalisation Account set up in the summer of 1932 (see Table 2).
Real interest rates fell quite dramatically and very quickly and gold reserves almost doubled within a year. By the end of 1936, the money supply had grown by 34% compared with early 1932 (Howson 1975).
The cheap-money policy followed the textbook approach for operating at the zero lower bound of seeking to reduce the real interest rate by raising inflationary expectations. A key aspect was that the Treasury under Chamberlain, rather than the Bank of England under Montagu Norman, ran monetary policy after the exit from the gold standard. The classic problem with the ‘foolproof way’, especially for central banks, is whether they can credibly commit to maintaining inflation once recovery appears to be under way. Because of its problems with fiscal sustainability, the Treasury was in a good position to persuade markets that it wanted sustained moderate inflation as part of a strategy to reduce the real interest rate below the growth rate of real GDP and to benefit from this differential in reducing the public-debt-to-GDP ratio. This reliance, based on ‘financial repression’, allowed more tolerance for lower primary budget surpluses and eased worries about ‘self-defeating austerity’ without a Keynesian approach to the public finances.
Obviously, for the cheap-money policy to work it needed to stimulate demand – a transmission mechanism into the real economy was needed. One specific aspect of this is worth exploring, namely, the impact that cheap money had on house-building. The number of houses built by the private sector rose from 133,000 in 1931/2 to 293,000 in 1934/5 and 279,000 in 1935/6 – many of these dwellings being the famous 1930s semi-detached houses which proliferated around London and more generally across southern England. The construction of these houses directly contributed an additional £55 million to economic activity by 1934 and multiplier effects from increased employment probably raised the total impact to £80 million or about a third of the increase in GDP between 1932 and 1934. House building reacted to the reduction in interest rates and also to the recognition by developers that construction costs had bottomed out; both of these stimuli resulted from the cheap-money policy (Howson 1975).

Read the rest of the article here.


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