Assets bought by the Bank of England in the Asset Purchase Facility source: B of E

The theory behind quantitative easing is that it should increase - the money supply, bank lending and economic activity.

To simplify the scheme.

• The Bank of England creates money electronically. (They just increase their balances.)
• They use this created money to purchase assets. (As you can see, so far, this is mostly government gilts - useful for financing government debt, though as the Bank says, this a pure co-incidental side effect...)
• Banks and financial institutions are selling their gilts to the Bank of England, therefore, they should have an increase in their money balances. In theory, with greater cash reserves, they should be willing to lend this out to private enterprise helping investment and economic activity.
• Also, by buying gilts, the price goes up and the yield (interest rate) goes down. This decline in gilt yields (interest rates) should also help to increase economic activity (more incentive to spend rather than save.

How Effective is It?

It is still difficult to say how effective the scheme is. It will be subject to time delays, and the economy may have been much worse than without it. However, data released by the Bank of England, suggests the UK is still suffering from low growth in the money supply and low economic activity. Whilst other countries like US and Eurozone are escaping recession, the UK may need further quantitative easing to boost its prospects.

An Adjusted Version of M4 Growth

• 
• An Adjusted measure of M4 fell 0.9% in September (OFC stands for other financial corporations)
  
• The household sector’s holdings of M4 rose by £3.0 billion in September. The annual growth rate fell to 2.5%.
• M4 lending (excluding the effects of securitisations etc) to the household sector rose by £1.6 billion. The annual growth rate fell further, to 2.0%.
• source: B of E
• M4 is a measure of broad money - It includes the amount of notes and coins in circulation, plus bank and building society deposits.

Related

• Link between Money Supply and Inflation
• Quantitative easing
  

2008, saw a precipitous decline in UK wealth. UK wealth fell to £5.8 trillion at the end of 2008. A decline of £844bn or 13%. The decline in wealth was a combination of a £394bn fall in housing wealth and a £450bn

Although, in 2009, house prices have stabilised and stock markets have showed signs of recovery, the outlook still looks bad with wealth expected to decline a further £251bn in 2010.

Whilst these declines in wealth are dramatic, they should also be placed in context of rapidly rising wealth during the long house price boom since the mid 1990s. Rising house prices contributed to growing wealth inequality between property owners and non-property owners. Wealth is still much higher than in the mid 1990s.

Impact of wealth on Economy.

Economists generally agree that wealth has at least some impact in influencing consumer spending. For example, rising house prices help to boost consumer spending for two reasons.

• Householders feel more confident to spend. Saving rates tend to fall because householders view housing equity as a form of saving. It is no coincidence the saving rate has started to rise as house prices have fallen.
• Equity withdrawal. Rising house prices give households the opportunity to remortgage their house and spend the extra money. This source of consumer spending was quite significant upto 2007. See: Graph of Housing Equity withdrawal
  

The impact of stock market wealth is perhaps less noticeable. Short term fluctuations have limited impact in effecting consumer spending. However, a prolonged, sustained fall does affect income from pension funds and investment trusts. When consumers realise the decline in their pension fund, they start to adjust the spending and may increase their own savings to compensate for lower pension funds.

Changes in wealth do not always directly affect consumer spending. Most households do not tie their spending to the value of their house. For most people a rise in house prices doesn't mean much because they can't access it. Although re-mortgaging is popular, it is only taken up by a minority of households.

Yet, the sustained decline in wealth we have seen since the start of 2008, will effect the economy in 2010 and 2011, lower wealth will lead to higher savings and make a recovery slower. The UK economy may have to look for more diverse sources of economic growth than consumer spending. - And that of course may be no bad thing.

After throwing everything at the economy, bar the proverbial kitchen sink, Britain's policy makers will be deeply disappointed to see the UK economy continue to decline, as the recession enters it's sixth consecutive quarter.

Source: ONS

Despite, zero interest rates, quantitative easing, tax cuts and a falling pound, the length of the recession is a reflection of how severe the credit crunch and asset bubble bursting was.

Whilst Germany and France have now recovered from recession, it is worth noting that largely they did avoid a property bubble and were not as dependent on the financial sector as the UK. The US and Spain, both of who shared a property bubble and bust, are also still in recession.

Yet, despite the continued downturn, which means the UK GDP has now declined 6%, and has become smaller than Italy's economy) the outlook is less grim than at the start of the year. Despite continued weak sales, confidence is surprisingly buoyant. Firms are hoping that the worst is over and the weak pound and recovery in the Eurozone will provide a good opportunities for growth over the medium term.

Yet, there are still various worrying signs which may delay the UK's recovery, meaning any recovery will remain anaemic.

• Prospect of House price falls. Nationwide recently reported a 6th month of property price rises. This is certainly very helpful for improving consumer wealth and confidence, but the fear is 2010 could see further house price falls as the supply of housing increases.
• VAT tax cut will expire at end of year
• Prospect of fiscal tightening to deal with record budget deficits.
• Continued rise in unemployment
• Nervous consumers looking to save not spend.
  

Baring an unforseen event, this should hopefully prove to be the last quarter of negative economic growth. Yet, it will prove a difficult balancing act to prevent growth remaining very slow in the near future.

Readers Question: Should Government Prevent Record Bonuses to Goldman Sachs and Staff of Bailed Out Banks Like RBS?

Goldman Sachs, the US investment bank which employs over 5,o00 people in London, will pay an average bonus of £500,000 this year. Like many of the remaining investment banks, Goldman Sachs have made huge profits this year.

It is claimed RBS is also intending to pay large bonuses to staff, even though RBS was bailed out by the Government. However, RBS claim any bonuses will have to be approved by UK Financial Investments, the company managing the governments 70% stake.

Why Are Banks Paying Such High Salaries?

• The Banking sector has become more profitable this year. This is partly due to the decline in competition as banks have been merged or folded. This decline in competition enables them to make higher charges.
• Banks claim the wages are a reflection of the workers worth to the firm. They argue, they need to pay high wages / bonuses to the best bankers otherwise they will struggle to get the best workers.

Arguments for Restricting Bankers Pay

• The banking sector only survived because of government intervention / bailouts and implicit guarantees. Therefore, the taxpayer has a right to intervene in the industry it saved.
• There is a sense of injustice that bankers who caused the crisis are benefiting from huge payouts, whilst many workers are being made unemployed.
• Excessive Bonuses were a contributory factor in creating a risky banking environment which led to the credit crisis and subsequent recession. See: Problem with bank bonuses
• Bank Pay partly reflects the greater monopoly Power that banks now have

Arguments Against Restricting Bankers Pay

• It may seem unfair that bankers get so much pay, but, if firms are willing to pay that amount, then it is an indication that according to free market principles they are worth the wage.
• Banker Pay is not the real issue. Arguably the government need to concentrate on regulating lending practises. Cutting Bank bonuses are just a populist measure which does nothing to create a better / more responsible banking sector.
• Banks will find a way around. If British banks can't attract the best workers, it will benefit foreign competition which will be able to attract the star investment bankers.
• The government / taxpayer will benefit through the collection of income tax at 50% on bank bonuses; these bonuses will help refill the treasury coffers.

Conclusion

The public's anger over bank bonuses is more than just populist anger. Excessive bonuses were a problem behind the credit crisis. The idea banks need to pay £9m to attract star bankers is somewhat thin. Are these the same star bankers who predicted the current crisis and suggested responsible lending practices? I doubt it.

Banks may say it is unfair for the government to intervene in setting their wages. But, is it not unfair the taxpayer had to bailout the irresponsible banking sector? Government intervention can't just be a one way ticket. If you need the taxpayer to bail you out of a crisis, you can hardly blame the taxpayer for wanting to limit excessive pay.

Yet, limiting bank pay is not the real issue. Cutting bank bonuses may make the public feel better, but, it will not, by itself, create a responsible banking sector.

• Difficult of bank regulation

A recent report, by Professor Steve Fothergill, suggests that the real level of unemployment is already closer to 3.4 million - much higher than the 1.6m official claimant count statistics suggest (link)

The report suggests the real unemployment level is higher because there are many people unemployed but not entitled to unemployment benefits. (see also: What is true level of unemployment in UK)

In September, the employment rate fell to 72% and the official unemployment rate rose to 8.0%

• National Statistics Online

Solutions to Unemployment

1. Demand Side Policies.

Undoubtedly, the main cause of unemployment is the current recession and output gap. With demand falling, firms have spare capacity and so are employing less workers. This is why we have:

• 0.5% interest rates
• expansionary fiscal policy
• Quantitative easing.

The problem is that these three demand side policies have been unable to stem the rise in unemployment. This does not mean they have been a complete failure. Without these policies to boost demand, the unemployment rate would be higher. The problem is these policies take time to have an effect.

Employment Subsidies

An employment subsidy could be given to firms who keep on workers part time during the recession. This saves the government the cost of unemployment benefits and prevents workers being idle and losing on the job training. However, the danger of employment subsidies is that they may be misused by firms who see an opportunity to gain extra income. It is also difficult for the government to decide which workers / firms to subsidise.

Cutting Minimum Wages

With stagnant nominal wage growth, the minimum wage is more at risk of causing real wage unemployment. - wages above equilibrium levels. A cut in minimum wages could create extra job opportunities. However, there is no guarantee that cutting wages actually creates jobs. Since the minimum wage was introduced in 1999, successive increases were compatible with a period of falling unemployment. Cutting wages would also reduce overall demand in the economy, creating less demand for workers.

Education and Training of Long Term Unemployed.

Whilst the majority of current unemployment is cyclical, even before the current recession there were pockets of structural unemployment related to a lack of skills. Relevant skills and training programmes would help the long term unemployed get back into work. Few economists would have any objection to the principle of retraining the unemployed. It is essential the skills and education is highly relevant to the needs of the workforce. However, it is a policy often easier to say than actually do. I don't know a time when we haven't talked about the need to improve education and training. But, I do believe that in the UK, too much emphasis is placed on getting 50% of young people a degree when insufficient money is spent on vocational training.

Reclassification of Incapacity Benefits.

The report mentioned above, suggests that many long term unemployed have been given incapacity benefits when there are still jobs they could do. Rather than conveniently putting people on incapacity benefits, more attention could be given to retraining workers for non-manual labour. The potential cost savings of reducing dependence on sickness benefits are significant. Though it will be a difficult balancing act to prevent those really incapable of work being withdrawn from necessary welfare support. Also, this policy will not reduce the official claimant count, but will increase employment rates.

Flexible Labour Markets.

Many economists have suggested high levels of structural unemployment are due to inflexible labour markets. For example, if it is difficult to hire and fire workers this can discourage firms from employing workers in the first place. Arguably this is a much bigger issue in European countries such as France and Spain.

Shorter Working Week.

The theory is that if workers are doing 40 hour weeks, then reducing the week to 30 hours will lead to an increase in the number of workers employed. However, in practise, it is rarely as simple as that. The shorter working week can also act as hindrance to firms.

Geographical Subsidies.

The geographical spread of unemployment is not as bad as in the 1980s, but the north south gap still exists. Of the top 20 areas of unemployment all are above the line from the Wash to the Severn. It is again manufacturing output in the UK's industrial heartlines that has been hardest hit. The fall in manufacturing output 13% is double the fall in GDP 6%. Subsidies / tax breaks may be need to encourage firms to open in relatively more depressed areas.

Weak Pound and Restructuring of Economy.

The weak pound does make UK exports more competitive. It may help manufacturing relative to the consumer sector. In the long term, when the global economy recovers, this boost in exports may help create manufacturing jobs in the north.

Related Posts on Reducing unemployment

• Reducing unemployment using monetary policy
• Reducing unemployment in Spain
• Reducing Natural Rate of Unemployment
  

The latest National Minimum Wage Rates from 1 October 2009 are:

• Workers Aged 16-17 – £3.57
• Workers Aged 18-21 – £4.83
• Workers Aged 22 and over – £5.80

On one of my posts, there have been many comments debating weather it is fair to pay young workers less than adults. see: National Minimum Wage Rates for Young Workers
Unfortunately, the recession and rising unemployment (forecast to over 3 million) means the minimum wage will come under closer scrutiny as firms struggle to meet wage bills.

A reader asks whether a recession could be solved by cutting the wage of premiership footballers. Rather like banker bonuses, footballers may not deserve such high wage, but, generally such inequality is not the cause of recessions.

Another readers asks - Where will economic growth come from for next year? - Many of the traditional sources of economic growth have been hit. House prices have fallen and in a period of uncertainty, consumers are becoming more attracted to saving than spending. It will be difficult to boost consumer spending.

At least someone is making profits in this recession - Google exceeds expectations and posts $1.6billion profit - saying worst of recession is over. But, the recession has been bad news for Champagne growers

CPI inflation fell to 1.1% last month. This is close to the lower end of the government's target for CPI Inflation (1-3%) In many ways, a fall in inflation below the government's target is more dangerous than being above the inflation target.

The prospect of deflation is particularly dangerous given the levels of personal debt in the UK. Deflation increases the real value of debt and could be a powerful disincentive to spend, hindering any recovery. More on inflation vs Deflation

The fall in GDP, low inflation and rise in unemployment all point to spare capacity and a large output gap.

Some commentators are already talking about tightening monetary and fiscal policy. But, given current data, such a move could prove premature and push the economy back into recession.

Output Gap


According to IMF estimates for 2009, the UK output gap is one of the largest in the OECD at over 3% of GDP.

Definition of Output Gap.

• The Output gap is the difference between Potential output and actual output.
• Output gap = Y - Yf where Y = actual output and Yf = potential output.
• A large negative output gap suggests a recession and spare capacity.
• A positive output gap suggest actual output is above potential output - Economic growth has exceeded the underlying trend rate leading to inflationary pressure.

Ideal Current Interest Rates

Paul Krugman does a back of the envelope calculation to show according to the Rudebusch version of the Taylor rule:

• Fed funds target = 2 + 1.5 x inflation - 2 x excess unemployment

The ideal interest rates would currently be -5.6% in the US. - An indication of the depth of the recession.

A frequent argument heard at the moment is that idea that the current levels of borrowing mean that we are taking money from future generations. A 15 year old girl recently gained headline for calling on Gordon Brown to apologise for a lost generation (link)


Government borrowing has increased dramatically in the past few years. From just under 30% of GDP to just under 60% of GDP in under 3 years is the sharpest peacetime increase in public sector debt burden.

If government debt as a % of GDP rises, then assuming constant interest rates the debt repayments will rise. Public sector debt is forecast to rise from 30% in 2007 to 80% by 2013. This is a very sharp rise in public sector borrowing. This means current and future taxpayers will have to pay more in interest payments over the next few years. In 2008, debt interest payments account for £31billion (2% of GDP). Debt interest in 2013/14 will exceed £51 billion. But, this figure could be higher if borrowing keeps increasing. To put it in perspective £40bn is equal to roughly 25% of all income tax revenue. £40bn is worth 8p on the basic rate of income tax.

Furthermore, if markets become worried over extent of government debt, and the UK's credit rating is reduced, the interest rate and cost of servicing debt is likely to rise even further as a result.

So future tax rises will be partly going towards paying increased debt interest payments.

Also, it is important to bear in mind.

• Public Sector debt has always varied. 30% was a historical low. In the 1970s it was 75%. In the 1950s over 200%.
• The massive national debt of the early 1950s hardly led to a lost generation. The 1950s and 1960s were a period of unparalleled prosperity and rising living standards.
  

• The rise in the government deficit was essential to avoid a Great Depression Mark II. If the government hadn't bailed out the banks. If the government hadn't tried to increase spending, the fall in confidence and output could have been disastrous. To allow a repeat of the Great Depression would have been the biggest cost to future generations. The borrowing offset the rise in private sector saving and helped a very weak economy recover. It is economic recovery which is the best hope for improving tax revenues and paying off debt.

Not all the debt, is due to counter cycling factors. There is also the underlying structural deficit related to the increased spending on health, education, social security and pensions. To borrow to pay for current pensions, is effectively to transfer payments from this economic period to future ones.

However, this generation is not unique in running a budget deficit. Historically, we have experienced much worse. This doesn't mean large budget deficits are good. In the medium term, the government needs to tackle the underlying budget deficit. But, the idea of a generation lost because of today's debt, would be a great exaggeration. Just think in 1945, public sector debt was 145%, what did the government do? Savage public spending cuts? No it introduced the national health care service and welfare state. It left office in 1950, with government borrowing over 180% of GDP. Yet, the 50s and 60s witnessed a golden age of economic expansion and rising living standards. So much for the idea of a lost generation....

For many years, emerging economies in the east have been quietly and modestly taking up a bigger share of the world's GDP. For a long time, China has sought to downplay its role, reluctant to flex its large economic muscle. It is still America who dominates global institutions such as the IMF and the World Bank and it is the dollar that currently remains the global reserve currency. But, the recent economic crisis has accelerated the slow and steady shift in economic influence. It is the Anglo Saxon economies that have been hit hardest by the global credit crunch and recession, which is perhaps deserved given the fact the crisis originated there. Amidst unprecedented falls in output and increases in unemployment, there is frequent talk of the US dollar being replaced as the world's reserve currency.

It is not as if, the US is going to disappear from the economic map and sink into obscurity. The US is still the most influential economy in the world, and it will remain one of the most influential be for the foreseeable future, but, it is no longer the undisputed powerhouse it was once. Emerging markets in China, India and Latin America will take a greater share of world GDP and trade. It is only inevitable that these changes will have to lead to changes in the composition of world bodies like the IMF and World Bank. There may be some resistance, but demographics and the seemingly unstoppable economic progress is firmly with the East / south. Whether we like it or not, sooner or later, we could be looking at the Chinese Reminbi and Indian Rupee with the same focus as we currently look at the fortunes of the US dollar and US economy.

Who Wins Who Loses?

The shift in economic power and influence is by no means all a bad thing. The old saying ' When America sneezes the rest of the world catches a cold' may soon become a thing of the past.

How can it be good for the world economy to be so reliant on the whims of the American consumer and American banks? The rise of a new consumer class in the East and Latin America will help create a more diversified world economy. The next time a property bubble and bust occurs in Florida, it may be that it no longer brings the world's financial system to its knees. This is surely no bad thing.

We may have to give up our seats on the IMF (or at least share them with more emerging economies). But, the growth of China and India could have some benefits for our economies in terms of greater trade and a rebalancing of our persistent current account deficits.

The real unknown factor is how the booming Asian economies will effect the global economy in terms of oil shortages, food shortages and the continued impact on global warming. These problems all have the potential to make this credit crisis look limited in impact.

Two years ago, the UK could boast one of the lowest public sector debt to GDP ratios in the OECD. Yet, within a short space of time, the UK has emerged with one of the highest annual budget deficits in the world. The budget deficit is forecast to be a huge £175bn touching 12-13% of GDP next year. This is much higher than the budget deficit of the 1970s, when the UK required a bailout from the IMF.

A significant part of the deficit is due to the recession and attempts to stimulate spending. In particular tax receipts, reliant on a booming property and stock market have collapsed, e.g stamp duty and income tax.

However, in addition to the cyclical factors, the low deficits of 2006, masked an underlying structural deficit which is predicted to worsen as demographic factors increase future pressures on government spending.

Although, fears of government borrowing in a recession are often misplaced, the undeniable fact is that sooner or later, the UK, will need to tackle this worryingly large underlying structural deficit.

Timing will be a fine balancing act. Cut the deficit too soon and too sharply, and we risk plunging the economy back into recession. Cut it too late and we risk unnerving the bond markets with an ever rising need for selling government bonds. It may be that we need to cut the deficit and, at the same time, hope monetary policy can maintain the fragile recovery.

But, with public sector spending reaching nearly 48% of GDP, there is a need to restrain it.

Choosing which sectors to cut will be no easy political matters. It is easy for politicians to say they will cut the unnecessary red tape / bureaucracy costs and leave underlying services. But, has there ever been a time when politicians have not said they will cut bureaucracy costs? Also it is the kind of deficit where trimming the edges and axing a few quangos will do little to make more than a dint on the underlying problem.

Labour say the NHS is a sacred cow and this will not be touched. But, it was health care which was the biggest beneficiary of the now seemingly extravagant spending rises in the boom years. (see: health care spending) 2/5 of this extra spending went to higher pay for doctor and nurses. Anyone fancy imposing a pay freeze on our dedicated nurses and doctors? (and I hope my sister isn't reading) Or does anyone fancy raising the retirement age to 75?

The problem is the deficit will need radical (i.e. politically unpopular choices), and some pressure groups are going to be more than a little upset.

The post on welfare benefits was not very detailed, but, it does touch on the huge figures of over £200bn we will be spending on social security every year. The press love to highlight cases of the government spending tens of thousands of pounds to house a family of 7 asylum seekers e.t.c. But, although it is populist politics, it is still true that we do spend enormous sums on welfare support. It is in areas like Social Security where we may have to find significant cuts. But, again it is a fine line between cutting out the benefit cheats and creating a more unequal society with more living in poverty.

As I've said before, it's not the best time to be the Chancellor of the Exchequer.

This year, the Dollar has continued its long term decline which has been in progress since 2000. Since April the dollar / Euro exchange rate has moved from €1 to $1.3 to €1 = $1.48

Why is the Dollar Weak?

1. US Appears Unconcerned about a weak Dollar.

The big crisis facing the US economy is the recession and unemployment approaching 10%. Though the Americans may not wish to admit it, the depreciating dollar will help their economy recover. The Weak dollar will make exports cheaper and imports more expensive and this will increase domestic demand. If the US government is not committed to maintaining strength of Dollar, markets fear it is more likely it will fall.

2. Large Budget Deficit.

The US has a large budget deficit at close to $12 trillion. With financial bailouts and stimulus packages, the deficit is likely to keep growing. Substantial parts of this deficit is owned oversees. This will be easier to pay back if the dollar is weaker.

3. Inflation concerns.

There is also a concern that a large budget deficit will encourage the US authorities to target higher inflation to 'inflate away the debt' At the moment, inflation in US is very low, and spare capacity means inflationary pressures are limited. However, there will be a temptation to continue quantitative easing which could be inflationary.

4. Global Reserve Currency.

Many countries are not happy that the US dollar is the dominant reserve currency. Countries have so many reserves in dollars, but they see these reserves falling in value because of the weak dollar. Therefore, they want to diversify which is why dollar is falling and gold price is going up.

5. Oil Priced in Dollars.

There have been reports arab countries are considering dropping the dollar as the main currency for trading oil. If this occurs, then there will be less need for dollars as countries use other currencies. This would hasten the demise of the Dollar as a global currency. (demise of dollar at Independent)

6. Trade Deficit.

The US has run a persistent current account deficit, which reflects it has more imports than exports. In the boom years, it could attract capital flows to finance this current account deficit. But, in the post credit crunch era, this is more difficult. The depreciation in the dollar is thus necessary to rebalance the long term current account deficit.

7. The Rise of the Euro and China.

For a long time, the US maintained a powerful economic and political hegemony. But, the US economy iss being eclipsed by China and other emerging economies. Also, the Euro, provides a real alternative to the dollar. The ECB seem much more committed to low inflation and stability of the Euro which makes it more attractive.

Does this mean the Dollar will Collapse?

1. The US don't mind a gradual depreciation, but, they wouldn't want to risk alienating investors through creating high inflation and a rapid depreciation. Also, when the economy recovers the outlooks may change.

2. The budget deficit is large in the US, but, it is not the only country to have a ballooning public sector deficit.

3. It is true, China and other countries want to diversify from the dollar. But, it is equally true, China has so many dollar reserves it has a vested interest in avoiding a collapse in the dollar. A collapse in the dollar wouldn't just hurt the US, it would hurt all the countries who have dollar reserves.

People want to diversify from dollar, but if they do it too quickly they could lose a lot.

see: Liquidity trap explained

Conventional economics suggests a cut in interest rates will boost spending, investment and aggregate demand. Ceteris Paribus, cuts in interest rates

• Reduce the cost of borrowing, making loans more attractive
• Reduce mortgage interest payments increasing disposable income for householders
• Make saving less attractive
• Reduce value of currency, increasing export demand.

However, in a liquidity trap, cuts in interest rates will be ineffective. A liquidity trap is a situation where zero / very low interest rates fail to stimulate consumer spending because consumers prefer to save. (e.g. because of low confidence, expectations of falling prices)

A significant cause of a liquidity trap is very low inflation rates or deflation. Deflation makes the real interest rate high and discourages spending.

Policies to Overcome a Liquidity Trap

Quantitative Easing. Quantitative easing is an attempt to increase the money balances of banks and firms. Here the Monetary authorities create money to buy assets such as government bonds. Buying bonds from financial institutions give the banks an increase in their bank balances and lowers the bond yields. In theory, this should encourage banks to increase lending. However, banks may just keep the extra money. On the other hand, if it really increases the money supply, there is a danger of inflation.

Helicopter Drop. Monetarists such as Milton Friedman have advocated bypassing financial intermediaries like banks. They argue banks may not lend their increased money supply but just hoard it and improve their balance sheets. Friedman said money could be given directly to consumers. This policy was termed a 'helicopter drop' to indicate the idea of a central bank dropping money from a helicopter. In practise it might involve something more dignified like sending a cheque in the post. If deflation is a real problem, the Central bank could give money credits which have to be spent by a certain date - to stop people just saving the extra money.

Keynesian Solution to Liquidity Trap

A Keynesian would emphasise the importance of creating positive inflationary expectations. But, would also place emphasis on the role of expansionary fiscal policy in crowding in idle resources. To offset the rise in private sector saving typical of a liquidity trap, they would advocate government borrowing to inject demand into the economy through financing investment projects.

• Liquidity trap and fiscal policy

A liquidity trap occurs when low / zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective. In this situation, even an increase in the money supply could fail to increase spending because interest rates can't fall further.

A liquidity trap means consumers' preference for liquid assets (cash) is greater than the rate at which the quantity of money is growing. So any attempt by policymakers to get individuals to hold non-liquid assets in the form of consumption by increasing the money supply won't work.

For a long time, the macro-economy was managed by changing interest rates. So it is quite a shock for policy makers to experience a situation where their main policy tool was no longer sufficient. Hence the range of unorthodox monetary and fiscal policies.

Liquidity Trap 2009

Base interest rates were cut to 0.5% in March 2009. For a considerable time, the economy remained in recession. Technically, the economy is now creeping back to positive growth, but, the economy remains sluggish. So 2009, has been a good example of a liquidity trap.

Why do Liquidity Traps Occur?

• Expectations of deflation. If there is deflation or people expect deflation (fall in prices) then real interest rates can be quite high even if nominal interest rates are zero. - If prices are falling 2% a year, then keeping cash under your mattress means your money will increase in value. The difficulty is in having a negative nominal interest rates (banks would be paying you to borrow money). There have been attempts to create a negative interest rates (e.g. destroy money in circulation but in practise it is rarely implemented.
• Preference for Saving . Liquidity traps occur during periods of recessions and a gloomy economic outlook. Consumers, firms and banks are pessimistic about the future, so they look to increase their precautionary savings and it is difficult to get them to spend. This rise in the savings ratio means spending falls. Also, in recessions banks are much more reluctant to lend. Also, cutting the base rate to 0% may not translate into lower commercial bank lending rates as banks just don't want to lend.
• Credit Crunch. Banks lost significant sums of money in buying subprime debt which defaulted. Therefore, they are seeking to improve their balance sheets. They are reluctant to lend so even if firms and consumers want to take advantage of low interest rates, banks won't lend them the money.
• Unwillingness to hold bonds. If interest rates are zero, investors will expect interest rates to rise sometime. If interest rates rise, the price of bonds falls (see: inverse relationship between bond yields and bond prices) Therefore, investors would rather keep cash savings than hold bonds.

Related

• Liquidity Trap and Fiscal Policy

Tomorrow

• Overcoming a liquidity trap