House is a popular television show about a Vicodin popping flawed genius doctor. Dr. House heads up the diagnostics team that attempts to solve the trickiest cases before the patient buys the farm. The plot formula goes like this: Dr #1- Is it x? Dr. #2 – No, it y Dr. #3- It can’t be we tested for that. Dr. House- You’re all wrong its Z, now where’d i put my pills?
So it goes with modern central banking. A growing number of market “Doctors” have diagnosed the US economy as suffering the onset of a liquidity trap. A liquidity trap is a “disease” that exhibits no additional decline in interest rates or uptick in output no matter the increase in monetary accommodation. (The IS/LM intersection is flat in Econ 200 parlance) The commonly prescribed treatment is fiscal expansion (shift the IS curve out). Patients (economies) suffering from Liquidity Traps should present a cluster of these symptoms: CB easing, Political restructuring reform, terminating old subsidies, ending special tax treatment, open market treaties and/or increasing household formation. The US presents closely enough to garner this diagnosis at first glance with some obvious exceptions. The Fed has responded with monetary easing aimed at increasing/targeting/holding the inflation expectation up.
As we discussed in our weekend post, the economy is showing a drop in activity around the periods of prior QE medication running out. Dr. Bernanke’s team has rapidly refilled (even upped) the prescription. Meanwhile, the case study in post credit cycle economic malaise-Japan- has upped treatment on its long catatonic patient. At 1%, the initial reaction has been positive. The inflation expectation target needed to escape their trap may correlate to a negative rate that would collapse the currency, however. Conversely, their treatment will affect the efficacy of our policy.
We continue to believe the diagnosis is wrong and thus output remains constrained. Structurally Trapped economies exhibit similar symptoms but the vast majority of monetary easing is directed at debt support from the prior cycle and political “reform” is timid and tilted toward inefficient industries. The primary beneficiaries of US stimulus were the banks and the auto industry. When the financial system absorbs the principle amount of CB ease, the Structural Trap calcifies in the political arena. Tax law skewed toward capital over labor fosters excess capacity that makes a credibly high inflation expectation target out of reach. ( Hence our interest in Abundance Economics) Corporate profits represent an unstable and high percentage of GDP over the short run and inequality gaps wider. When the equilibrium level of interest is negative, the return on economy-wide capital is negative by definition.
The treatment of a Structural Trap can come in two forms and we advocate a blend. 1) Radical governmental reform at the tax and subsidy level coupled with capacity liquidation. 2) An increasing nominal interest rate term structure. Since sequestration is austerity’s red-headed step child and radical political reform seemingly impossible, the second option must be applied quickly. The Fed should concentrate its efforts in the 0-5 year bucket (Twist remains a policy mistake in our opinion) and allow the term structure to increase to levels well beyond prior cycles. Only then could markets feed back to corporate and investor participants that we have escaped the Trap and economic decisions be adjusted.