How Much Of The World Is In a Liquidity Trap?

As I’ve written many times in various contexts since the crisis began, being in a liquidity trap reverses many of the usual rules of economic policy. Virtue becomes vice: attempts to save more actually make us poorer, in both the short and the long run. Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster. Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners’ expense. For the moment — or more likely for the next several years — we’re living in a world in which none of what you learned in Econ 101 applies.

But what’s the definition of a liquidity trap? How much of the world is in one? There’s a lot of confusion on that point; here’s how I see it.

In my analysis, you’re in a liquidity trap when conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero.

Now, you may object that there are other things central banks can do, and that they actually do these things to some extent: they can purchase longer-term government securities or other assets, they can try to raise their inflation targets in a credible way. And I very much want the Fed to do more of these things.

But the reality is that unconventional monetary policy is difficult, perceived as risky, and never pursued with the vigor of conventional monetary policy.

Consider the Fed, which under Bernanke is more adventurous than it would have been under anyone else. Even so, it has gone nowhere near engaging in enough unconventional expansion to offset the limitations created by the zero lower bound.

A while back Goldman estimated that if it weren’t for the lower bound, the current Fed funds rate would be minus 5 percent, and that to achieve the same effect as a further 5 points of Fed funds cuts the Fed would have to expand its balance sheet to $10 trillion; I wouldn’t stake my life on those estimates, but they seem in the right ballpark. Obviously, the Fed isn’t doing that.

Or put it a different way: suppose the real economic outlook were the same as it is — with all indications being that unemployment will stay very high for years to come — but that the current Fed funds rate were, say, 4 percent. Clearly the Fed would feel obliged to engage in a lot more expansion, cutting rates sharply and rapidly. But with short-term rates at zero, the Fed is instead merely on hold — it is not expanding its quantitative easing, and is in fact in the process of pulling back.

The point is that while you can think of things the Fed can do even at the zero lower bound, that lower bound is in practice a major constraint on policy. By all means let’s yell at the Fed to do more, but when you’re considering other issues — like the effects of fiscal policy or the effects of renminbi undervaluation — you have to assess them in terms of the central bank you have, not the central bank you wish you had.

And by that criterion, how much of the world is currently in a liquidity trap? Almost all advanced countries. The US, obviously; Japan, even more obviously; the eurozone, because the ECB probably couldn’t engage in Fed-style quantitative easing even if it wanted to, given the lack of a single backing government; Britain. Not Australia, I guess. But still: essentially the whole advanced world, accounting for 70 percent of world GDP at market prices, is in a liquidity trap.


Paul Krugman