Monday, September 14, 2015

The UK and the Liquidity Trap

I had an interesting exchange of tweets with Nick Shaxson and the hated Sam Bowman of the ASI (or is that Sam Bowman of the hated ASI) on the subject of companies hoarding cash. Sam suggested that companies hoarding cash was not a problem, I suggested that it would be in a liquidity trap to which he asked if the UK is or was in a liquidity trap (or if such a thing really exists). I think it is the case that we are essentially in a form of liquidity trap, so what follows is the way I intuit the basic IS-LM model with regards to the UK economy. I'd also add that Krugman

So first off, the basic IS-LM model is based around a static closed economy with a goods market and a money market. In the money market we find an equilibrium between the demand for bonds that give a return at an interest rate (i) and cash. The goods market is governed by good old Output(Y) = (C - T) + I + G with the level of investment being determined by the interest rate hence giving us the downward sloping IS curve. A liquidity trap occurs when we get a situation a bit like the one below with the yellow lines, in the money market demand for money is so low at the given level of output that consumers are indifferent between holding cash and bonds. I've also put a more normal scenario where we are above the ZLB in green.



Translating the model into the real world can be a bit tricky, but I think it's reasonable to look at the rate on government debt as a good guide to where interest rates are at. In terms of money supply, I think here we can interpret moves by the bank to loosen policy (lower interest rates, QE) as shifting the money supply curve right. Finally, in terms of growth, I don't think we should necessarily assume that growth shifts the IS curve right, instead I'd interpret this as a sign of how "hot" the economy is. We can see growth despite the kind of zero lower bound equilibrium of the yellow and blue lines, shifts in "output" in this diagram manifest through fluctuations in the overall rate of growth. A low equilibrium output is seen in the form of slow growth, excessive austerity could shift the IS curve left to the point of causing a recession.

The liquidity trap I describe here is one of output being depressed through keeping aggregate demand low through austerity. The main place I see it here is in the money market equilibrium, the low interest rates on what we might classify as bonds are a sign of depressed output and a loss of economic potential, I think we are seeing the results in the form of below trend output (see this from Simon Wren-Lewis). In terms of other things that might justify us being in a liquidity trap, I think we can also look at the two textbook insights:

  • In a liquidity trap fiscal policy is very effective
  • In a liquidity trap monetary policy is very ineffective


Both those insights seem like a fair assessment of our current situation.

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