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The Wonderful Liquidity Trap

July 18, 2012

When short term interest rates on government debt are 0%, they can’t go any lower, because no one would be willing to exchange a government security which yields 0% (cash) for one which has a negative yield and is less liquid (short term bonds). When the equilibrium interest rate falls below 0%, central bank policy becomes stuck* at the zero lower bound. Exchanging one 0% government security for another does nothing to stimulate the economy, and the economy becomes stuck in a liquidity trap. Under the liquidity trap theory, since the central bank cannot lower the interest rate, they cannot increase inflation, and people will simply horde the additional money, just as they were hording the 0% short term bonds.

Where I differ from most economists is that they lament when the economy is in a liquidity trap, but I rejoice. If printing money does not result in inflation, public finance becomes a magical world, where all our dreams come true. The government debt can be instantly eliminated – just print the money and pay for it! If that does not cause inflation, we can abolish the IRS permanently – just print the amount of dollars the government would have collected. By the liquidity trap line of reasoning, so long as the printed money is not spent directly on goods and services, it will never increase spending so long as it does not reduce interest rates.

At this point, most Keynesian economists will say that if taken to the extreme, monetizing the debt and canceling taxes will cause higher inflation, perhaps even hyperinflation. But if monetizing 100% of debt causes hyperinflation, and monetizing 10% doesn’t cure deflation, surely there is a middle ground where you get modest inflation. The only problem is finding out where that middle ground is. If you do think that monetizing the entire debt will cause high inflation, then monetary policy is never ineffective. If you don’t think quantitative easing will ever cause higher spending, my question is this: why not print more?

* – Not really, but for the sake of this article, let’s suppose so.

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