NYTimes.com Article: Fear of a Quagmire?

From: Rakesh Bhandari (rakeshb@STANFORD.EDU)
Date: Sat May 24 2003 - 03:14:55 EDT

Quagmire=liquidity trap.

Fear of a Quagmire?

May 24, 2003

Suddenly the d-word is on everyone's lips. Last weekend the
International Monetary Fund released a rather ominous
report titled "Deflation: determinants, risks and policy
options." The report made headlines by suggesting that
Germany is likely to join Japan in the falling-price club.
Alan Greenspan hastened to reassure us that the U.S. isn't
at imminent risk of deflation. But alert Greenspanologists
pointed out that he seemed to hedge his bets, and the fact
that he even felt obliged to discuss the issue showed that
he was worried.

Though talk of deflation fills the air, most of that talk
is subtly but significantly off point. The immediate danger
isn't deflation per se; it's the risk that the world's
major economies will find themselves trapped in an economic
quagmire. Deflation can be both a symptom of an economy
sinking into the muck, and a reason why it sinks even
deeper, but it's usually a lagging indicator. The crucial
question is whether we'll stumble into the swamp in the
first place - and the risks look uncomfortably high.

The particular type of quagmire to worry about has a name:
liquidity trap. As the I.M.F. report explains, the most
important reason to fear deflation is that it can push an
economy into a liquidity trap, or deepen the distress of an
economy already caught in the trap.

Here's how it works, in theory. Ordinarily, deflation - a
general fall in the level of prices - is easy to fight. All
the central bank (in our case, the Federal Reserve) has to
do is print more money, and put it in the hands of banks.
With more cash in hand, banks make more loans, interest
rates fall, the economy perks up and the price level stops

But what if the economy is in such a deep malaise that
pushing interest rates all the way to zero isn't enough to
get the economy back to full employment? Then you're in a
liquidity trap: additional cash pumped into the economy -
added liquidity - sits idle, because there's no point in
lending money out if you don't receive any reward. And
monetary policy loses its effectiveness.

Once an economy is caught in such a trap, it's likely to
slide into deflation - and nasty things (what the I.M.F.
report calls "adverse dynamics") begin to happen. Falling
prices induce people to postpone their purchases in the
expectation that prices will fall further, depressing
demand today.

Also, deflation usually means falling incomes as well as
falling prices. In a deflationary economy, a family that
borrows money to buy a house may well find itself having to
pay fixed mortgage payments out of a shrinking paycheck; a
business that borrows to finance investment may well find
itself having to pay a fixed interest bill out of a
shrinking cash flow.

In other words, deflation discourages borrowing and
spending, the very things a depressed economy needs to get
going. And when an economy is in a liquidity trap, the
authorities can't offset the depressing effects of
deflation by cutting interest rates. So a vicious circle
develops. Deflation leads to rising unemployment and
falling capacity utilization, which puts more downward
pressure on prices and wages, which accelerates deflation,
which makes the economy even more depressed. The prospect
of such a "deflationary spiral," rather than the mere
prospect of deflation, is what scares the I.M.F. - and it

A decade ago all of these fears might have been dismissed
as mere theoretical speculation. But in Japan the whole
nasty scenario is playing out, just as the theory predicts.
And about five years ago I and other economists began
writing academic papers pointing out that what can happen
in Japan can happen elsewhere. (Part of the I.M.F. report
draws on my work on the subject.)

So how seriously should we take the risk that something
similar will happen in the world's other major economies?
Neither the United States nor Europe, outside Germany, is
likely to experience serious deflation in the next year or
two. But that's the wrong question - and we should bear in
mind that Japan's economic malaise took a long time to turn
into all-out deflation.

In fact, it's striking how gradually Japan's catastrophe
unfolded. When the stock bubble of the 1980's burst,
Japan's economy didn't fall off a cliff. By and large the
economy continued to grow, if slowly, and the nation didn't
have a severe recession until 1998. But year after year,
Japan underperformed, growing less than its potential.
Though the Japanese government tried to stimulate the
economy using the usual tools - deficit spending, interest
rate cuts - it was never enough. By 1995 or so the economy
had slid into a liquidity trap; by the late 1990's it had
entered into a deflationary spiral.

Our own situation is strikingly similar in some ways to
that of Japan a decade ago. Like Japan circa 1993 or 1994,
the United States is now facing the aftermath of a huge
stock market bubble - the Nikkei and the Standard and
Poor's 500 both tripled in the five years before their
respective peaks.

Also like Japan, we face a problem not of sharp downturn
but of persistent underperformance - an economy that grows,
but too slowly to prevent rising unemployment and falling
capacity utilization.

What's different is that we have Japan as a cautionary
example. Is forewarned forearmed?

Whatever reassurances Mr. Greenspan may offer, the staff at
the Fed is very worried about a Japanese scenario for the
United States - a concern reflected in their research
agenda. In a major study of Japan's experience published
last year, Fed economists reached two key conclusions.
First, Japan could have avoided its current trap if
policymakers had been aggressive enough, soon enough. But
by the time they realized the danger, it was too late.
Second, the Japanese weren't stupid: their relatively
cautious policies in the first half of the 1990's made
sense given not only their own forecasts, but also those of
independent analysts. But the forecasts were wrong - and
the Japanese had failed to take out enough insurance
against the possibility that they might be wrong.

The Fed has taken these conclusions to heart. Once the U.S.
economy began to falter, it cut rates early and often,
trying to get ahead of the problem. Those cuts certainly
helped moderate the slump; but at this point, with the
overnight interest rate down to 1.25 percent, the Fed has
almost run out of room to cut. (Fed officials believe, for
technical reasons, that going below 0.75 would be
counterproductive.) And the economy remains weak.

The Fed still has some tricks up its sleeve. Now would be a
very good time to announce an inflation target. But it's
also clear that the Fed could use some help, at home and
abroad. Alas, it's not getting that help.

The Fed's European counterpart, the European Central Bank,
has been far less aggressive in cutting rates. There are
economic, institutional and psychological reasons for this
passivity, but the central bank's immobility is one main
reason why Germany seems set to follow in Japan's
footsteps. European governments aren't much help, either.
Bound by the "stability pact," which limits the size of the
deficits they are allowed to run, they have been cutting
expenditures and raising taxes even as their economies

The Bush administration is, of course, notably unconcerned
about deficits. Aren't the tax cuts in the pipeline exactly
what the economy needs? Alas, no. Despite their huge size -
if you ignore the gimmicks, the latest round will cost at
least $800 billion over the next decade - they pump
relatively little money into the economy now, when it needs
it. Moreover, the tax cuts flow mainly to the very, very
affluent - the people least likely to spend their windfall.

Meanwhile, state and local governments, which are not
allowed to run deficits - we have our own version of the
stability pact - are slashing spending and raising taxes.
And both the spending cuts and the tax increases will fall
mainly on the most vulnerable, people who cannot make up
the difference by drawing on existing savings. The result
is that the economic downdraft from state cutbacks (only
slightly alleviated by the paltry aid contained in the new
tax bill) will almost certainly be stronger than any boost
from federal tax cuts.

In short, those of us who worry about a Japanese-style
quagmire find the global picture pretty scary. Policymakers
are preoccupied with their usual agendas; outside the Fed,
none of them seem to understand what may be at stake.

Of course, it's possible, maybe even likely, that their
nonchalance will be vindicated. Most analysts don't think
we'll find ourselves caught in a liquidity trap. And even
the Fed believes - or is that hopes? - that a surge in
business investment will save the day.

But few analysts saw the Japanese quagmire coming either,
and there is now a significant risk that we will find
ourselves similarly trapped. Even so, we won't have
deflation right away. But by the time we do, it will be
very hard to reverse.

Like the Fed, I hope that doesn't happen. But hope is not a
plan. нн



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