Monday, January 30, 2012

OUR LIQUIDITY TRAP

"A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels. http://en.wikipedia.org/wiki/Liquidity_trap

How did we get here? Excessive leveraging by the commercial and private sectors. Because of large Federal budget deficits, I had expected runaway inflation since 2001. Even now with Federal deficits shockingly high, I have read that the total debt (government plus companies plus private) in the country is decreasing because of rapid company and private debt deleveraging. I didn't recognize this and didn't understand why runaway inflation was not coming. Eventually I came to recognize that Federal deficits will have little effect on inflation because we are in a liquidity trap. In fact most of the developed world seems to be in a liquidity trap. Before that I invested in bonds and CDs nervously expecting their value to be consumed by inflation. I had avoided commercial bonds and preferred stocks my whole investing career of more than 50 years because of inflation fears. Once I became convinced that Federal pumping of money into the economy would have little effect, my fears were overcome and I entered all three investments with some gusto. At first I bought commercial bonds and preferred stocks timidly in the last decade, but as time went on I have become more bold. So far, so good. In fact our preferred stocks are often all above par,and some have gotten so far above par that I have sold a few for capital gains. (For preferred stock investing see: http://stopcontinentaldrift.blogspot.com/2011/11/preferred-stock-investing.html)

A problem with liquidity traps is that no one seems to know how to get out of them. Of course, I believe that at some time, some year, we will get out of it and have real, maybe even runaway, inflation, but I have no idea when that will be. I certainly don't have the feeling that we are close to it. In fact, the more austere we become in trying to lower our rapidly growing national debt, the more the liquidity trap probably will be prolonged. There are some encouraging signs, however, that our economy is slowly recovering, but I think that serious and runaway inflation is still some years off. When the company and private deleveraging is complete, then the situation may reverse?

1 comment:

  1. It's clear you know little if anything about economics. Inflation is not a problem in the US because banks are unwilling to lend except to those who don't need the money. When you have huge amounts of money on deposit and a risk-averse banking system you can't expect a growing economy or rising inflation. Period.

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