The IMF chief economist sees a threat to world economies from a liquidity trap

In the Financial Times from November 2 2020, the IMF chief economist Gita Gopinath suggested that world economies at present are likely to be in a global liquidity trap. Gopinath has reached this conclusion because the yearly growth rate of the price indexes has been trending down despite very low interest rates policies. According to the IMF chief economist, central banks have lowered interest rates to below 1 percent and in some countries interest rates are at present negative. In the framework of a liquidity trap, it is held that the ability of central banks to stage an effective defense against various economic shocks weakens significantly. So how then can one resolve the problem of the central banks inability to produce the necessary defense of the economy?

A possible way out of the liquidity trap suggests Gopinath, is to employ aggressive loose fiscal policy. This means an aggressive government spending in order to boost the aggregate demand.

According to Gopinath,

Fiscal authorities can actively support demand through cash transfers to support consumption and large-scale investment in medical facilities, digital infrastructure and environment protection. These expenditures create jobs, stimulate private investment and lay the foundation for a stronger and greener recovery. Governments should look for high-quality projects, while strengthening public investment management to ensure that projects are competitively selected and resources are not lost to inefficiencies.

Furthermore, according to Gopinath,

The importance of fiscal stimulus has probably never been greater because the spending multiplier — the pay-off in economic growth from an increase in public investment — is much larger in a prolonged liquidity trap. For the many countries that find themselves at the effective lower bound of interest rates, fiscal stimulus is not just economically sound policy but also the fiscally responsible thing to do.

What exactly is the liquidity trap that the IMF chief economist is warning us about?

Liquidity trap – what is it all about?

This popular framework of thinking originates from the writings of John Maynard Keynes, where economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings. For instance, if for some reason people become less confident regarding the future, they will cut back their outlays and hoard more money. Therefore, once an individual spends less, this will worsen the situation of some other individual, who in turn will also cut his spending. A vicious circle sets in – the decline in people’s confidence causes them to spend less and to hoard more money. This lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the growth rate of money supply and aggressively lower interest rates. Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money, so it is held.

In his writings, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to such a level from which they would not fall further. As a result, the central bank will not be able to revive the economy. This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that interest rates should subsequently rise, leading to capital losses on bond holdings. As a result, people’s demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply. As a result, this is going to undermine the circular flow of money and the economy will plunge into an economic slump.  On this Keynes wrote,

There is the possibility, …..that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.[1]

Once an economy is seen to be weakening in the midst of very low interest rates policy, most economists regard this as a sign that it has fallen into a liquidity trap.  Once this happens, if some other policies are not introduced it is held that the economy is doomed to be stuck in a stage of permanent stagnation. To prevent this from happening it is recommended that authorities should embrace an aggressive fiscal policy stance. This means that the government should step in and spend aggressively. The spending can be on all sorts of projects. Because of this spending, it is held, the consumer confidence is going to strengthen. With a higher level of confidence, consumers will lower their savings and raise their expenditure.

Does monetary expenditure cause economic growth

In the Keynesian framework, the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this implies they save less. Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed that they save more. In this way of thinking, saving is considered bad news for the economy – the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)

Observe however, that people do not pay with money as suggested by the Keynesian framework of thinking, but rather with goods that they have produced. The chief role of money is as a medium of exchange. Hence, the demand for goods is constrained by the production of goods and not by the amount of money spent as such. (The role of money is to facilitate the exchange of goods).

Paraphrasing Jean Baptiste Say Mises wrote,

Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.[2]

To suggest that people could have an almost unlimited demand for money that supposedly leads to a liquidity trap would mean that people do not exchange any longer money for goods. Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note people demand money not in order to accumulate it but to employ in exchange). Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer.

Real savings is the heart of economic growth

Various tools and machinery, or the infrastructure that people have established is for only one purpose and it is to be able to produce the final consumer goods that are required to maintain and promote people’s life and wellbeing. The quantity and quality of various tools and machinery determines the quantity and quality of final consumer goods. With more and better capital goods i.e. tools and machinery, the workers ability to produce more goods and of an improved quality is likely to increase. What permits the expansion of capital goods is real savings, which is the amount of consumer goods produced less the consumption of these goods by the owners of these goods. Note that real savings sustain various individuals that are engaged in the various stages of production.

The greater the production of consumer goods, all other things being equal, the larger the pool of saved consumer goods i.e. the pool of real savings is going to be. A larger pool of real savings can now sustain more individuals to be employed to enhance and expand the infrastructure. This of course means that through the increase in real savings, a better infrastructure can be built and this in turn sets the platform for a higher economic growth.

Higher economic growth means a larger quantity of final consumer goods, which in turn permits more savings and more consumption. With more savings, a more advanced infrastructure can be generated and this in turn sets the platform for a further strengthening in economic growth.

Note that the savers here are wealth generators. It is wealth generators that save and employ their real savings in the build-up of the infrastructure. The savings of wealth generators are employed to sustain various individuals that specialize in the making and the maintenance of the infrastructure. (Real savings also sustain individuals that are engaged in the production of final consumer goods).

According to Mises,

“The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way.”[3]

Now is it valid to argue that the expanding monetary flow supports economic growth? If this were to be the case, then most third-world economies would have eliminated poverty by now through printing large quantities of money.

Any attempt to grow an economy by means of monetary pumping results in the diversion of real savings from wealth generators to wealth consumers. It results in the depletion of the pool of real savings. This in turn undermines the process of real wealth generation.

Can government really grow an economy?

The whole idea of the IMF chief economist that the government can grow an economy originates from the Keynesian multiplier[4]. On this way of thinking an increase in government outlays gives rise to the economy’s output by a multiple of the initial government increase.

We hold that in similarity to loose monetary policy, loose fiscal policy is going to set in motion a diversion of real savings from wealth generating activities to non-wealth government supported activities.

To provide the support for the increase in government outlays government would have to divert real savings from the private sector of the economy. This means that wealth producers in the private sector are going to part with their real savings to support individuals that are employed in various government projects that are likely to be on a lower priority list of individuals. This in turn weakens the production of wealth and within all other things being equal, weakens the pool of real savings.

It follows then that not only does the increase in government outlays fail to raise the overall output by a positive multiple, but on the contrary the increase in government outlays will result in the weakening of the process of wealth generation in general.

Again, loose fiscal policies by boosting consumption whilst weakening the process of real wealth generation is going to undermine the pool of real savings.

According to Mises,

…there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.[5]

Liquidity Trap and the Shrinking Pool of Real Savings

As long as the growth of the pool of real savings stays positive, this can continue to sustain productive and non-productive activities. Trouble erupts however, when a structure of production emerges that tie up much more consumer goods than the amount it releases as a result of continuous loose monetary and fiscal policies over time. (The consumption of final consumer goods exceeds the production of these goods).

The excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings. As a result, fewer activities can be now introduced. This in turn results in the economy plunging into a slump.

Once the economy falls into a recession due to the falling pool of real savings, any government or central bank attempt to revive it is going to fail. Not only will these attempts fail to revive the economy, they will deplete the pool of real savings further, thereby prolonging the economic slump.

The shrinking pool of real savings exposes the erroneous nature of the commonly accepted view that loose monetary and fiscal policies can grow an economy. The fact that central bank policies become ineffective is not due to the liquidity trap, but because of the decline in the pool of real savings. In the framework of a declining pool of real savings, fiscal policies are also going to be ineffective. We suggest that the policy ineffectiveness is always present whenever the central authorities are attempting to “grow an economy”. The only reason why it appears that these policies do “work” is because the pool of real savings is still expanding.

Conclusion

Contrary to the popular thinking, we suggest that if world economies were to fall into a liquidity trap i.e. the monetary policy ineffectiveness, the key reason for this is not a sharp increase in the demand for money as such, but because of the depleted pool of real savings. Major contributing factors to this depletion are previous loose monetary and fiscal policies.

We suggest that policy ineffectiveness is always present when the central authorities attempt to “grow the economy”. The only reason why the illusion that central authorities can grow the economy appears to be real is due to a still expanding pool of real savings.

The IMF chief economist recommendation to counter the so-called liquidity trap by boosting fiscal spending will only make things much worse through a further depletion of the pool of real savings. What is required to revive world economic growth is to provide businesses with the free environment for growing the economies. For this to occur it is required to close all the loopholes for the generation of money out of “thin air” and to cut government outlays to the bone. In addition, there is the need to remove various regulations on businesses that undermine their ability to generate real wealth. Again, the key to economic prosperity is the generation of abundancy of real wealth. We suggest that only businesses and not government bureaucrats are capable to achieve this.


[1] John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan & Co. Ltd. (1964), p. 207.

[2] Ludwig von Mises, Lord Keynes and Say’s Law, The Critics of Keynesian Economics, edited by Henry Hazlitt, University Press of America 1983, p. 316.

[3] Ludwig Von Mises, Human Action, Contemporary Books, p.490.

[4] J.M. Keynes. The General Theory of Employment, Interest and Money, Macmillan & Co. LTD 1964, p. 129.

[5] Ludwig von Mises, Human Action ,3rd revised edition, Contemporary Books Inc, p. 744.

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