Posted by Milos Sugovic
Repeated gasps of air in the midst of an incoming recession flood come from interest rate cuts by the Fed. But how long before the U.S. economy enters a liquidity trap a la Japan?
Each cut is intended to kick-start growth. With investment and consumption inversely related to interest rates, monetary policy helps jerk output toward the positive direction. So every time we hear of the Fed cutting rates, should we celebrate? Not quite.
Ask the Bank of Japan about its experience during the 1990s. The government and central bank double-teamed deflationary pressure. Nominal interest rates were cut repeatedly and the government resorted to Keynesian spending, widening the budget deficit. But with a whopping deficit, zero real interest rates and imported inflation, Japan became a textbook example of a liquidity trap. Sound familiar?
The U.S. is exhibiting similar early signs: cutting interest rates, importing inflation, and running an elephant budget deficit that's not even news anymore.
So how close is the U.S. to Japan's situation? Paul Krugman says, "Pretty close."
There is one important caveat, however: Japan and the U.S. are on opposite ends of the spectrum relative to the golden rule savings rate. Encouraging spending in the U.S. is not as challenging, and that might be keeping the economy afloat.
At the end of the day, there's a limit to monetary policy, and the Fed's surely approaching it. The government, on the other hand, is going to need some creative solutions.
Perhaps they should look for ideas in the Clinton-Greenspan bag of policies.
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