Lying is an Easy Way to Reflate

The whole problem with monetary policy in a liquidity trap is the inability for a central bank to commit to a permanently expanded monetary base. Iterations of this dilemma are captured best by Paul Krugman’s quip that the Fed cannot “credibly commit to be irresponsible”.

Actually, it can. We have a Fed that cannot actually be irresponsible. Markets know the second inflation hits 3-5% the brakes are coming hard, which asphyxiates expansionary fire today. Nothing short of complete institutional change of a decentralized system like the Federal Reserve can change it’s limitation.

But the Fed doesn’t actually need to be irresponsible, it must only convince markets that it can be. I suggest Ben Bernanke release a statement – or, better, the FOMC as a whole in its minutes – that he is expecting 5% annual inflation, even if he is expecting far less. That way, the FOMC privately knows deflation exists and quantitative easing will not do anything, and continue the huge asset purchases. But the market will be confounded. The world’s most conservative institution is ignoring inflation at even 5% – surely that means the brakes won’t come down all too hard in the future.

This will immediately provide traction to monetary policy even at the zero lower bound and will prevent the complete sterilization of expanded base as we currently experience.

In fact, even a Federal Reserve of many inflation hawks can do this successfully. They personally know deflation is real, but they can hide that private knowledge. Of course the markets will know the real PCE and CPI, but the only metric that’s important is the Fed’s own expectation.

Or we could completely reform the Federal Reserve, but that’s the real #slatepitch here.

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1 comment
  1. Ralph Musgrave, “The “liquidity trap” is bunk, cr*p and drivel all rolled into one.”

    The New Palgrave Dictionary of Economics starts its definition of the liquidity trap as “A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective.”

    Wikipidia’s definition is not much different. It starts thus. “The term liquidity trap is used in Keynesian economics to refer to a situation where the demand for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Therefore, if the economy enters a liquidity trap area — and further increases in the money stock will fail to further lower interest rates — monetary policy will be unable to stimulate the economy.”

    This is all nonsense on stilts. It is clap trap. Do advocates of the liquidity trap seriously think that if every household in the country was given £10,000 in cash there’d be no effect? What do people do when they win a lottery? The … lottery winners SPEND their winnings (or a sizeable chunk of it)…

    …By way of keeping the debate on the liquidity trap going, economists often point to the fact that Japan greatly increased its money supply in the 1990s to little effect. Well of course there wasn’t much effect: this money supply increase was done via quantitative easing. That is Japan’s central bank gave people cash in exchange for the latter’s bonds. Well what’s the big difference between cash and bonds? Not much. They are both fairly liquid forms of saving. That’s why there was little effect.

    Increasing the money supply and giving it all to people who are determined to put it on their compost heap and rot it down into compost will have no effect. But to argue from this that ALL money supply increases have no effect, is clearly nonsense. At least for mentally retarded three year olds, the nonsense is clear enough.

    Finally, it should be said that some definitions of the liquidity trap consist of the idea that recessions can persist despite interest rates being zero – in which case fiscal policies are required. That is, some advocates of the liquidity trap are arguably well aware of the fact that printing enough money and dishing it out to households will solve the problem…

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