The Liquidity Trap

All this economy shit (henceforth, this will be the manner in which I refer to our current financial mess), was caused, chiefly, by the fact that we took the single most important price in our economy, the price of money, otherwise known as interest rates, out of the hands of the market and placed it under the control of a bunch of people who, as best I can discern, are in possession of no superpowers, giving them unchecked control over the amount of money we have out there chasing whatever goods are available in the economy. (Note that I did not use the phrase "in my opinion." Get used to that.) Sadly, as men with no obvious super powers are wont to do, they fucked it up. They created far too much money far too quickly and made it so cheap that banks found it reasonable to use it in ways that had far too low a probability of paying out (they loaned it to poor people).

Given that this is what caused the problem in the first place, the policy of creating trillions of dollars more and giving it to the very same banks who are known to behave rationally when they are given cheap money (by taking risks that they might not otherwise take and that we'd all prefer they not take), seems a bit like accidentally blowing up a house and then attempting to use more dynamite to blow all the pieces back into place. In the short-run, though, at least it will have the predictable effect of keeping all the pieces in the air a little while longer.

Or will it? It appears perhaps not. The problem is that money is already so cheap, with interest rates getting very near zero, that creating more and more money can't reduce its price significantly enough to spur more risky lending on the part of the banks to get the economy going again, or at least get the pieces of the economy high enough into the sky that we forget that they've already come apart. What's worse, the increasing supply of money may be decreasing the banks' willingness to use it in the frivolous manner for which our friends at the Fed had hoped. Whereas, before the banks had rationally responded to cheaper money by throwing it at people who didn't know what to do with it, they now seem to be rationally responding by hanging onto every cent they can. But why?

The reason may lie in the fact that these banks are not making their decisions based on the interest rates that we see on the front page of the paper, the nominal interest rate, but on the expected real interest rate, or the nominal interest rate minus expected inflation. When expected inflation is high, which the recipients of trillions of dollars in newly created money must figure it is, and the nominal interest rate that banks are paying the fed is near zero, a couple of things happen. The real interest rate banks are paying becomes negative. In other words, the fed is paying the banks to take all this new money off their hands. The other thing that happens is that the real rate that the banks are charging borrowers (this will never be negative, as banks, unlike the gov't, are operating with the goal of turning a profit), is reduced dramatically, decreasing their incentive to inject this money into the broader economy.

This is the source of the liquidity trap, where money is poured into the financial sector with no results as the banks just hold onto it. Don't get the impression that this is good for the banks, though. It doesn't matter how much cheaper future money will be than today money if they have no source for future money. Whereas you and I may be able to go out and build widgets for a day and make $20k in future money to pay off the car we buy with borrowed today money, the bank doesn't really have many such options. Unless they dramatically increase checking account fees, they're just stuck paying back their trillion dollars in today money, plus whatever interest they owe, with the same trillion dollars they've been holding onto.

So why would the banks bother? They really don't have much of a choice as long as there are other banks out there facing the same dilemma (or as long as the government forces them to take the money whether they want it or not). If none of the other banks take the money, a bank is better off to be the only one taking it because inflation may not be so bad (at least until the gov't figures out another way of getting the new money into the economy), and they have lots of cheap money to play with. If all of the other banks take the money, the individual bank is forced to accept the possibility that this money will make it into the economy, inflation will happen anyway, and it will be left with lower capitalization and, as a result, less market share than its competitors. In short, all the banks will take the money, despite being aware of the fact their lives will suck more as a result.

So what's the solution to this liquidity trap? Stop doing the shit that causes it. The more money we give to the banks, the more they will fear inflation. Without the money actually becoming any cheaper for them, this can only decrease the amount they're willing to put into broader circulation. Paradoxically, the Fed could actually increase the flow of money by contracting the money supply.

No one else I've read has put forward this theory, at least not in this way; so it is either really stupid or really brilliant, though I think the efficient market hypothesis suggests it's probably the former. Someone explain to me why.