Fed: We Are In A Liquidity Trap Which Can Only Be Cured By Inflation

Federal Reserve Bank of Chicago President Charles Evans said we are in what Keynesians call a “liquidity trap“:

A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero – so that injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes.

In order to make monetary policy “effective” during a recession, they say you have to stimulate the economy by creating price inflation. They create price inflation by printing money (quantitative easing or QE). This will free up all those dollars that savers are “hoarding.” What this will do, according to Krugman and Keynes, is cause people to spend because they will see that inflation is depreciating their dollars and there is no use continuing to maintain high savings. This new spending will break the “trap” and people will spend, businesses will borrow, and banks will lend. But it won’t work unless people know that the Fed really means it when it comes to creating inflation. If they think the Fed will “chicken out,” then folks will just hold on to savings during economic uncertainty and they won’t spend. So, the Fed really needs to push the money pedal hard.

This is all quite zany, but most modern economists believe it. They think that by debasing the currency they are actually creating real economic growth that will be sustained once the money pumping stops. They ignore the fact that people are doing the rational thing by paying down debt and increasing savings to prepare for the lean times. They do that by not spending as much. Thus, these economists say, we are trapped in this spiral of low consumer spending and high savings which tanks the economy. They think people are stupid so they believe they must trick savers into spending by devaluing the currency. They are right: if they create enough inflation folks will certainly want to dump deflating dollars.

These “modern” economists ignore the need to deleverage and the need for malinvested capital tied up in unprofitable ventures to be liquidated and then reinvest capital in new profitable ventures. They ignore inflation’s distortion of the economic function of the act of saving which gives false go signals to producers of higher order goods (goods that take a long time to make). They ignore the creation of a new boom-bust business cycle based on a papered over mirage of fake profits. They ignore the fact that once the inflation stops, the economy collapses again.

President Evans is a big QE guy and he has been writing a lot about it lately and he has a vote on the Fed’s policy decisions (member of FOMC).  Mr. Evans favors a “targeted inflation rate” which means they will print money until they achieve their desired inflation target of about 2%. Oh, and here is the latest idea which various Fed economists have invented: the “inflation deficit.” What they mean is that they can create price inflation higher than 2% for a while because since we’ve had price inflation below the 2% target we can sort of average out to 2% inflation over time. Hey, you can never have enough inflation according to these guys.

Here’s how they think it will work:

Click to enlarge

I hope you appreciate the 13% devaluation of the dollar by 2014.

Evans cites Keynesian economist Paul Krugman, among others, as a source for research that this will work (Krugman, Paul R., 1998, “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap,”Brookings Papers on Economic Activity, Vol. 29, No. 2, pp. 137–187.) You should know that Japan tried most of the things that Krugman had recommended during their decades long slump, without success. In other words these econometricians have created models of aggregate demand and production (you are reduced to an autonomic unit) by which they think they can pull a money lever and achieve a desired outcome. As if these models have worked well lately.

QE won’t work to save the economy, but it will work to create inflation. Because of the lack of formation of real capital that savings creates and the failure to deleverage the economy, we will experience stagflation instead of the desired robust real economic growth.

This should give you a bit of a pause when you consider the quality of economic thinking coming out of the Fed. If you trust the Fed, you shouldn’t.  The only frame of reference these guys have is some form of Keynesian economics. It was the Fed that got us into this mess to begin with and it is like giving the keys back to the guys who drove the bus off the cliff.