For My Next Trick, I Will Fall Into This Here Trap...

I noticed that recently there has been a "surge" in the readership of this blog and some readers were even kind enough to provide encouragement and valuable criticism in the comments section. Thank you.

Please note that in the interest of brevity I may sometimes quickly pass over whole sections of knowledge in the presumption that readers are familiar with the subject. I recognize that this is not always so, but it would be cumbersome for most to constantly repeat material, particularly if I have already dealt with them in previous posts. I encourage new readers, if they have the time and inclination, to read some older posts. Alternatively, if some financial terms are unfamiliar there are tremendous encyclopedic resources in the Internet these days, e.g. Investopedia is a fine tool for basic information.

Back to our regularly scheduled program..
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Apart from combating inflation, the Fed's mandate includes maintaining economic stability, which is officialese for "avoid recessions - but if you can't, make damn sure we get out of 'em ASAP". The main instrument at its disposal is setting the cost of short-term money via targeting the Fed Funds rate, i.e. what banks charge each other for overnight money. It is a weapon with one critical built-in defect, as the Bank of Japan can readily testify: Once interest rates go to zero the central bank is out of conventional ammunition for stimulating the economy. This is known as the "liquidity trap": once you are in it... good luck getting out. You can't set nominal interest rates below zero because no one will pay interest to have his/her fiat money on deposit with a bank - not for very long, anyway*.


(If you want to experience first hand the thrills and chills of running your own central bank, visit the Swiss National Bank's site, where they have an excellent monetary policy simulation program - a sort of internet game for money geeks. All I can tell you without spoiling the fun is that you will walk away with a much greater appreciation for the challenges of a central banker's job. Lots and lots of humble pie for us backseat monetary policy amateurs.)

Because of the trap, a careful central banker tries to stay as far away from the "hole" as he/she possibly can. Mr. Bernanke's now infamous speech about raining money from a helicopter, a joke originated by his mentor Milton Friedman, refers to just such a "liquidity trap" and how to get out of it - at least theoretically.

How is the Fed doing on this "stay as far away from the hole as possible" front? Not too well, I'm afraid. As you can see in the chart below, during the past 35 years, before every recession (indicated in grey) Fed Fund rates were anywhere from a low of ~7% to a high of ~18%, i.e. there was plenty of room to cut substantially in order to stimulate the economy.


Where are we now? Because in this cycle the Fed started raising rates from such a record-low level, it only managed to get to a high of 5.25% - the lowest post-recession peak since 1960 - before stimulation in the form of rate cuts was necessary once again (indicating, also, how shallow the recovery really was). The Fed is starting with significantly less ammunition in its monetary policy gun than ever before, while at the same time faced with runaway debt, a massive current account deficit and a tumbling dollar.

There is another very powerful monetary policy tool: the statutory ratio of bank reserves to deposits. It sets how much of the depositors' money can be lent out and is the way to control credit growth directly. For example, a 10% reserve ratio can ultimately create $1000 credit out of $100 of deposits, as the money lent out is re-deposited from one bank to the next. The Fed's ratio for non-transaction deposits (e.g. savings accts. that limit the number of withdrawals, CD's, time deposits, etc.) is now 0% - can't get any lower than that. For checking and other such transaction deposits the ratio is 10%.

From the above it is obvious that the Fed doesn't have much wiggle room before hitting the bottom of the trap at 0% interest rates, implying that very soon policy makers must look elsewhere for economic stimulation: financial/asset bubbles are exhausted as levers for growth.

Where should they/we look? Call me a romantic, but I believe widespread economic prosperity is not a matter of finance, but of industry. In the past several years we have put the cart (finance, assets, consumption) before the horse (R&D, innovation, production) and we are now caught in a bind. In my opinion it is time to correct this and have finance once again follow and serve the interests of industry. Our world is faced with immense challenges from resource depletion to climate change that cannot be dealt with by finance alone - or the consumerist technology of games and cell phones. We need to reclaim our global technical and political leadership position in "harder" industries, from alternative energy to environmental protection.

We now, sadly, lag - and that's is no place for America.

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(*) There has been a notable exception: Switzerland in the late '70s had negative rates for a short period because foreigners kept piling into the Swiss franc, expecting FX gains.