Like a car, an economy has lots of moving parts; everyone thinks they know how to drive it when they’re in the back seat; and it crashes too often. But on a more serious note, the analogy of a car works especially well when you think of where large parts of the global economy are.
Today central banks can make money cheap and plentiful, but the money that is created isn’t moving around the economy or stimulating demand. They can step on the accelerator and flood the engine with gas, but the transmission is broken, and the wheels don’t turn. Without a transmission mechanism, monetary policy has no effect.
This has not always been the case, but it is today. After some credit crises, central banks can cut the nominal interest rate all the way to zero and still be unable to stimulate their economies sufficiently. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’s original meaning). The Great Financial Crisis plunged us into a liquidity trap, a situation in which many people figure they might just as well sit on cash. Many parts of the world found themselves in a liquidity trap during the Great Depression, and Japan has been stuck in a liquidity trap for most of the time since their bubble burst in 1989.
Economists who have studied liquidity traps know that some of the usual rules of economics don’t apply when an economy is stuck in one. Large budget deficits don’t drive up interest rates; printing money isn’t inflationary; and cutting government spending has an exaggerated impact on the economy. In fact, if you look recessions that have happened after debt crises, growth was almost always very slow. For example, a study by Oscar Jorda, Moritz Schularick, and Alan Taylor found that recessions that occurred after years of rapid credit growth were almost always worse than garden-variety recessions.
One of the key findings from their study is that it is very difficult to restore growth after a debt bubble. Central banks want to create modest inflation and thereby reduce the real value of debt, but they’re having trouble doing it. Creating inflation isn’t quite as simple as printing money or keeping interest rates very low. Most Western central banks have built up a very large store of credibility over the past few decades. The high inflation of the 1970s is a very distant memory to most investors nowadays.
And almost no one seriously believes in hyperinflation. The United Kingdom has never experienced hyperinflation, and you’d have to go back to the 1770s to find hyperinflation in the United States – when the Continental Congress printed money to pay for the Revolutionary War and so started a period of extremely high inflation. (That’s why the framers of the Constitution introduced Article 1, Section 10: “No state shall … coin money; emit bills of credit; make any thing but gold and silver coin a tender in payment of debts….”)
Japan and Germany have not had hyperinflation for over sixty years. Today’s central bankers want inflation only in the short run, not in the long run. As Janet Yellen recognized, central banks with established reputations have a credibility problem when it comes to committing to future inflation. If people believe deep down that central banks will try to kill inflation if it ever gets out of hand, then it becomes very hard for those central banks to generate inflation today. And the answer from many economists is that central bankers should be even bolder and crazier, sort of like everyone’s mad uncle or, more politely, to be “responsibly irresponsible,” as Paul McCulley has quipped.
In a liquidity trap the rules of economics change. Things that worked in the past don’t work in the present. The models of economies that we mentioned above become even less reliable. In fact they sometimes suggest actions that are in fact actually quite destructive. So why aren’t the models working?
Sometimes the best way to understand a complex subject is to draw an analogy. So with an apology to all the true mathematicians among our readers, today we will look at what we can call the Economic Singularity.
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