US consumers fight the Fed
Remember the Keynesian liquidity trap?
What is the opposite of a liquidity trap?
The idea that an economy could be caught in a liquidity trap was popularized by New York Times columnist and economist Paul Krugman in the aftermath of the financial crisis, but the concept goes back at least as far as John Maynard Keynes. The basic idea is that there are times when consumers, businesses and investors are determined to conserve cash rather than spend or invest it, even when interest rates are low. After the collapse of Lehman Brothers, there was a lot of talk about investors simply wanting “yield”. of assets” rather than a “return on assets.”
Falling into a liquidity trap complicates economic policy-making. The central bank can cut interest rates, but that will do little to stimulate growth. It may even encourage more precautionary savings from households and businesses, as rate cuts send the message that the economy is in serious trouble.
This is often combined with the idea of a “balance sheet recession” which happens when companies and households seek to repair their balance sheets by reducing their debt and increasing their liquidity. In a balance sheet recession, even near-zero interest rates will not incentivize companies to expand by borrowing as they strive to reduce leverage. The same applies to households: cut interest rates as much as you want, in a financial recession people just don’t feel comfortable borrowing to spend more.
The Keynesian response to liquidity traps and balance sheet busts is fiscal expansion. If the private sector does not want to borrow to spend and invest more, the government can act as a sort of borrower of last resort. By spending more than it collects in revenue at a time when households and businesses are trying to do the opposite, the government can essentially act to closing the “spending gap” it stunts growth.
Can the government really spend to get by?
At least, that’s the theory. An obvious problem with this solution is that the same concerns that drive people to seek austerity for their businesses and households also encourage a austerity policy. Investors want to own companies with strong balance sheets, households want to build their nest egg, and voters want fiscally responsible politicians. The problem, of course, is that since everyone’s income comes from the spending of others, a collective decision to reduce spending by households, governments and businesses means that income must also fall.
The other problem is that additional public spending could encourage households and businesses to save even more precautionary. Maybe deficit spending just sends a signal that tough times are upon us and so it’s time to tighten our belts. Perhaps people fear that today’s debt will have to be repaid tomorrow by more taxes; so they start saving to pay the tax burden. Just as an accommodative monetary policy could encourage households and businesses to adopt economically restrictive behaviors, expansionary fiscal policy can trigger financial tightening.
The Unstoppable American Consumer
Over the decades, much ink has been spilled in economic journals and pixels have spilled on the financial corners of the internet on issues related to liquidity traps and efficiency or the possibility of fiscal and monetary responses. We can safely leave them aside for now as it is not our problem. We are not facing a conventional liquidity trap. We have something like the opposite.
The Federal Reserve has raised the federal funds rate by 525 basis points since last March. This is a record rate of monetary tightening. As Fed Chairman Jerome Powell said in his recent Jackson Hole keynote address, this would generally mean that the monetary policy stance has turned tight. Yet economic growth has accelerated this year, defying predictions that we would enter a recession.
Federal Reserve Chairman Jerome Powell walks the grounds during the Jackson Hole Economic Symposium in Moran, Wyoming on Aug. 24, 2023. (David Paul Morris/Bloomberg via Getty Images)
Consumer spending rose 0.8 percent in July in nominal terms. After adjusting for inflation, consumer spending rose 0.6 percent. The real-time reading of the Atlanta Fed’s Gross Domestic Product shows we have real growth of 5.6 percent. Although this figure is likely to fall, it is unlikely to give the impression of an economy “hampered” by a “restrictive” monetary policy.
Neil Dutta, who heads US economic research at Renaissance Macro Research, is one of the few economists who correctly understood that employment and consumer spending would keep the economy from falling into recession this year. On Monday, he said the economy was growing nominally at about 6 percent.
“We still have an unsustainable and strong economy,” Dutta told Bloomberg’s Monitoring program.
When in a liquidity trap, easing monetary policy cannot induce people to spend and invest more. Today we find that tighter monetary policy is failing to get people to spend and invest less. The economic tide continues to rise even though the Fed has said it is time to ebb.
A serious question is whether this is happening because of a series of economic situations in which monetary policy has become ineffective – first a liquidity trap, then a liquidity tide – or whether monetary policy itself is bound to be less efficient than many economists thought. Maybe it’s always been that way. Or maybe we have just entered a post-monetary era.
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