Demand liquidity trap vs Supply liquidity trap

Ben Emons of PIMCO in this central bank focus edition (written with 4 others) says we have 2 kinds of liquidity traps:

A liquidity trap has a two-sided definition. There is a demand liquidity trap that speaks to demand for money being inelastic to interest rates. That is, the level of savings rises well above the level of investment even with interest rates being excessively low. This is what’s called a “Keynesian liquidity trap,” where money is “trapped” between incentives to save and to spend. A liquidity trap could also be supply driven. In this case a central bank provides excess liquidity to the banking system, and the liquidity gets deposited back onto the central bank’s balance sheet when it isn’t taken up.

Either way, the money never enters the real economy. Liquidity is abundant, but it remains disconnected from risk taking.

He does not discuss this but I think the chain of thought goes like this. As there is a huge demand shock, central banks push rates to zero. This leads to demand LT as Keynes explained. Central banks try and cure this demand LT by expanding balance sheets. They hope that more money will lead to economic activity. However, banks just reinvest the monies back in central banks or  do not really withdraw their excess reserves with central banks:

Since the financial crisis, central bank balance sheets have dramatically increased, but so have their deposit facilities where commercial banks park excess cash. Despite dramatic monetary easing, the supply-driven liquidity trap has become very real, as shown in Figure 1. The economics of earning 25 basis points on excess reserves or cash on deposit appear to outweigh the benefits of reinvesting the funds into other assets or lending them out. At the same time, private sector deleveraging has continued in most major economies despite record low borrowing rates.

These dynamics have led to a not seen before combination of both a demand and supply type liquidity trap, a reflection of potential “bimodal” outcomes. (Unlike a typical bell-shaped curve of statistical likelihood, with a single peak and low-probability tails on either side, a flatter or even bimodal (dual-peaked) distribution suggests greater uncertainty over the range of potential outcomes, including extremes – “fat tails” – that may be more likely to occur.) 

What Figure 1 demonstrates as well is that the liquidity trap is not even: Some central banks have been more aggressive in providing liquidity (Swiss National Bank) than others, while some central banks are just catching up (European Central Bank).

He says there could be more traps ahead and EU crisis could lead to a global liq trap. This could lead central banks lending directly to the economy:

At an uneven speed of private and financial sector deleveraging, global central banks have to guard against additional traps materializing. Although there has been credit creation in the U.S., the risk of a credit crunch in Europe remains high and could serve as fuel to a global liquidity trap. This may require even more provocative forms of monetary easing, whereby central banks perhaps could end up lending directly to the real economy without bank intermediation. That would be the “tipping point” for the liquidity trap to dissolve into a potential bout of inflation. Until then, the policy rates have to remain near zero bound. 

Hmmm..Anything is possible in this multi-modal world..

Bill Gross in his latest piece expands further on the theme:

In addition, Credit Suisse, in their “2012 Global Outlook,” devoted considerable pages to specifics of zero-based money with commonsensical historical comparisons to Japan over the past decade or so. The following pages of this Outlook will do the same. At the heart of the theory, however, is that zero-bound interest rates do not always and necessarily force investors to take more risk by purchasing stocks or real estate, to cite the classic central bank thesis. First of all, when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street. 

He adds zero rates are a risk in itself:

What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.” Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension. But modern capitalism is dependent as well on maturity extension in credit markets. No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns. Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan. A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains. This nominal or even real interest rate “margin” is why prior cyclical periods of curve flatness or even inversion have been successfully followed by economic expansions. Intermediate and long rates – even though flat and equal to a short-term policy rate – have had room to fall, and credit therefore has not been trapped by “price.”

When all yields approach the zero-bound, however, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sovereigns, then the dynamics may change. Money can become less liquid and frozen by “price” in addition to the classic liquidity trap explained by “risk.” 

 Though the yield curve is positively sloped, the overall curve has shifted much lower providing very little incentives to banks:

Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation. What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount. Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit. 

As money cannot really go into a mattress as it is too large a volume, central banks remain the best place to park. And liquidity trap continues.

Finally it is all about the economic cycle:

Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.

 Hmm..

I have just covered the economics in the article. There is some superb linkage of life cycle to economic cycle in the first part of the article which is a great read.  Gross continues his top writing form. Only if this could be converted to cricket form, he would have been a great help to Indian cricket team even though he is above 60!!

Advertisement