A Liquidity Trap?

"Putting somebody who is suffering from anorexia on a diet doesn't make a lot of sense to me." - Paul McCulley

A liquidity trap is loosely defined as a period in which the private sector delevers their balance sheet of debt or increases their savings rate at which time reducing interest rates has no effect on aggregate demand as there is no desire to accept more debt regardless of how cheap.  During these periods the Keynesian economists believe that the only way out of this trap is to have the government shoulder more debt until such time as the private sector has cleaned itself up and is ready to start to grow again.  In this argument, cutting government spending and stimulus during this period is suicide as this will lead to further contraction and exacerbate the problem.

The main example of how this worked in real life was back during the great depression era.  The great depression ended in large part to WWII.  The massive influx of spending from the government produced the stimulus needed to pull the economy out of its malaise.  Furthermore the GI Bill helped millions of Americans returning from the war purchase a house and get retrained.  In those times it was considered a privilege rather than a handout (as it would be today).  Having been in combat myself I can assure you that it is a privilege that is deserved whereas right now it is definitely a handout.

At present there is a global call for governments around the world to delever their balance sheets and this could push the entire global economy over the edge.  I must admit that to some extent I agree with this argument.  Cutting government spending would mean cutting jobs and this would lead to an increased unemployment level reducing demand for goods and services even further.  On the other hand having the government spend more money sends a chill down my spine.  So why is that and what are the differences between then and now?

The difference between the government spending money on a war and spending money during peace time are significant.  During a war you send away (or employ) thousands of people to fight, many of whom never come back.  This contracts the workforce significantly.  During WWII it resulted in there being a lack of employable men to run the factories so the women stepped into that roll.  Furthermore the government spent money on factories and innovation, a direct stimulant to the economy that required immediate employment.  The result was that after the war the boom continued and lasted for decades as the private sector stepped in to monetize the opportunities.

Today we see a government that is bent on spending but the use of the money is what is exasperating.  To date we have spent more than $3 trillion to fix nothing.  Had the government used that money to hire people to work factories and innovate rather than sink it into the hands of a few large failing banks and businesses we would have a different outlook.  People would be back to work rather than collecting unemployment checks for 99 weeks.  This would have the effect of turning our current pessimistic outlook into a positive outlook and we have all seen what happens when everyone believes in the future - the future is bright. 

The current pessimism around the world is a factor of a poor economy AND a lack of leadership.  If it were just a poor economy people would be of the mindset that the vacation this year may have to be cancelled. Adding in weak leadership and people start to think that not only will we not go on holiday this year but we will never go on holiday again.  Furthermore they begin to question the government spending programs and start to call for austerity right at the time when we need the government to step up spending.

Do we still have time to fix this?  I believe that we do, however I do not think it will happen until we have a leader that takes the helm and drives the ship away from the rocks towards which we are headed.  At present we have the capacity to take on more debt.  Due to the weakness around the globe every country is trying to weaken their currency.  With everyone trying to weaken stimulating more should not create a capitulation in the dollar.  The problem therefore is not that we are unable to print more money (like Greece) but that if we do we will not spend it in the correct manner.

Based on this it certainly appears that the economy will stagnate for a longer period than anyone is prepared to accept.  My view is that at present we are locked into this malaise until the property market clears and that is looking like at least another five years if not longer.  Low interest rates are here for the foreseeable future as well as there is no demand to borrow from the private sector.  Furthermore inflation seems to be contained as there is such an output gap that further stimulus from the government should keep a lid on this for the foreseeable future.  In addition the price of raw materials is falling as weak demand is starting to seep into those prices.  For example oil is down more than 25% from its recent highs.

In this environment stocks will not perform well and there will be limited opportunities to make money on your investments in the traditional ways.  Look to alternative investments and once you have found an opportunity make sure that you scrub it down thoroughly as often times the risks associated with the investment will far outweigh the potential rewards.