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Are We Stuck Pushing on Strings?

The Great Liquidity Trap

by ROBERT POLLIN

Since the onset of the Great Recession in 2008, commercial banks in the United States began accumulating huge cash reserves in their accounts at the Federal Reserve. Thus, in 2007, just before the onset of the Wall Street crash and ensuing recession, commercial bank reserves at the Fed totaled $20.8 billion.

By the end of 2008, that figure had ballooned to $860 billion. By the middle of 2011, it had reached $1.6 trillion, where it remains. This is more than 10 percent of U.S. GDP, an order of magnitude for commercial bank cash holdings that is without precedent since the Federal Reserve began reporting such statistics systematically.

The banks obtained most of these funds through borrowing within the federal funds market—the market for short-term interbank loans—nearly for free, since the Federal Reserve pushed their policy target rate, the federal funds rate, close to zero in December 2008. The Fed has held the federal funds rate at close to zero since then, and Fed Chair Ben Bernanke has announced that the Fed plans to keep the federal funds rate at near-zero at least through 2014.

Over this same period that the banks built up these massive cash reserves, credit stopped flowing into the non-corporate business sector in the U.S. For these smaller businesses, total borrowing fell from $546 billion in 2007 to negative $346 billion in 2009—a nearly $900 billion reversal. The non-corporate business sector overall

continued to obtain zero net credit over both 2010 and 2011. This pattern is especially damaging coming out of the severe employment crisis created by the recession, since, on average, smaller businesses are relatively labor intensive, and thus typically serve as a major engine of job creation during economic recoveries.

These conditions in credit markets over the Great Recession and subsequently are hardly unique relative to previous recessions, in the U.S. and elsewhere, and the 1930s Depression itself. Indeed, this contemporary experience represents just the most recent variation on the classic problems in recessions in reaching a “liquidity trap” and trying to “push on a string.” This is when banks would rather sit on cash hoards than risk making bad loans, and businesses are not willing to accept the risk of new investments, no matter how cheaply they can obtain credit.

Under such circumstances, conventional central bank open-market operations—i.e. lowering the target short-term policy—is greatly weakened as a tool for pushing an economy out of a recession and toward a healthy recovery.

The liquidity trap that has prevailed since the 2008-09 recession has served as a major headwind, counteracting the effects of what, on paper, has been a strongly
expansionary macro policy stance by the U.S. government in the face of the Wall Street crash and recession. The expansionary policy measures included the nearly $800 billion, 2-year Obama stimulus program, the American Recovery and Reinvestment Act (ARRA).

The ARRA was financed by an increase in the federal government’s fiscal deficit that was unprecedented over the post World War II period. The fiscal deficit reached $1.4 trillion, or 10.1 percent of U.S. GDP in 2009 and $1.3 trillion, or 9.0 percent of GDP, in 2010.

In terms of Federal Reserve Policy, in addition to the near-zero interest rate monetary policy, Chair Bernanke dramatically expanded the Fed’s lending facilities during the recession to include mortgage brokers, money market funds, and insurance companies. The Fed also purchased commercial paper directly immediately after the recession.

Finally, the Fed engaged in two rounds of quantitative easing, beginning in November 2008 and November 2010 respectively, which involved the Fed purchasing long-term Treasury bonds in an effort to directly bring down long-term lending rates. Despite all of these measures, the recovery out of recession has been weak and fitful. The threat of a double-dip recession is ongoing.

Under this combination of circumstances, the Fed’s near-zero interest rate has indeed amounted to pushing on a string. But that does not mean that there are no policy tools available through which the central bank can gain leverage within the current-day liquidity trap—i.e. to develop the capacity to pull on the string.

Among the range of policy proposals that have been made in the contemporary literature, I have argued that the two most widely discussed—i.e. raising the inflation rate and depreciating the dollar—are not likely to provide policymakers with significant new leverage within the liquidity trap.

However, three other proposals are more likely to be achieving significant new policy leverage. First, the Fed could undertake open market operations on private assets, with the aim of directly bringing down long-term rates for business borrowers. The failure of quantitative easing interventions was not that they were targeted at long-term rates in general, but that they were directly influencing long-term Treasury rates only. This intervention meant that the interest rate spread between long-term Treasuries and private bonds grew, since the quantitative easing policies did nothing to reduce the risk premium embedded in long-term private rates.

But even more promising, the Fed could impose maximum reserve requirements, which would be the equivalent of an excess reserve tax. Along with this stick of a policy, the federal government should then provide a carrot of substantially expanding the federal loan guarantees for smaller businesses. Through this combination of measures, the government would be aiming policy interventions with precision at two central problems associated with the liquidity trap. That is, banks would become forced to pay a price for hoarding excess cash reserves, while both the banks and non-financial businesses would see the high risks of borrowing/lending fall sharply. Moreover, these policies can be implemented on a large scale with only modest impact on the federal budget.

To estimate the costs to taxpayers of a loan guarantee program for smaller businesses, let’s assume that $300 billion in new small business loans are guaranteed.  This would then be in addition to the current total of about $800 billion in various sorts of federally guaranteed loans.  Let’s assume this $300 billion in new loan guarantees carry a 90 percent guarantee.  Then assume that the default rate on these loans is of 3.5 percent , twice the rate in 2007.  Under these circumstances, the net government liability is $9.5 billion (i.e. $300 billion x 0.9 x 0.35). This is, of course, a whole lot of money, but it is also only ¼ of one percent of federal government spending.  One could also adjust the calculations based on an increase in either the default rate or the extent of the guarantee. But overarching fact is that the overall impact of such a measure on the federal budget would be modest within any reasonable range in terms of the level of the guarantee and the default rate.

Such policies for escaping the liquidity trap will have to be combined with a new round of fiscal stimulus policies to directly bolster aggregate demand. The dismal performance of the U.S. economy since the fiscal crisis began in 2008 has made clear that only through combining an expansionary fiscal stance with equally expansionary credit market policies—i.e. policies capable of pulling on a string—will the U.S. economy have a fighting chance of achieving a strong and sustainable recovery out of the Great Recession.

This article is adapted from Robert Pollin’s paper The Great Liquidity Trap: Are We Stuck Pushing on Strings? Working paper with the Political Economy Research Institute , forthcoming in Review of Keynesian Economics.

Robert Pollin’s latest book is Back to Full Employment (MIT Press).