Liquidity Traps, Credit Crunches, the Past Two Recessions, and Interest Rates on Long-Term BBB Debt

Jack Healy and Vikas Bajaj tell us that the cost of borrowing has zoomed up:

But with the credit markets still tight, corporations are being forced to pay much higher interest rates than they did a few years ago, putting more strain on balance sheets already hammered by falling profits and a grinding recession.

For those of you who have heard we are in a liquidity trap, remember that this refers to short-term interest rates on government debt whereas Healy and Bajaj are talking about long-term corporate debt. Interest rates on 20-year Federal bonds aren’t that high but credit spreads are:

Even companies with strong credit ratings are paying about 5 percentage points more than the federal government to borrow money, according to Standard & Poor’s. That is more than double the premium they paid last January. Companies with so-called junk credit ratings are paying a 15 percent premium. “That’s an extraordinary spread,” said Diane Vazza, head of global fixed-income research at Standard & Poor’s. “That’s unprecedented in the speculative-grade market.”

Sloped Curve takes these market rates to suggest that Paul Krugman is wrong about the liquidity trap argument:

Professor Krugman is also discussing only one side of the issue when it comes to where the economy is today. Professor Krugman is taking the fact that the US is in a liquidity trap for granted, and that the US is wrestling with the zero-lower-bound for interest rates, even though there are obvious reasons for why you would argue that the US is not in or near a liquidity trap ... the economic actors are not exposed to 0% interest rates. No final loans to private individuals or companies are made at or near a 0% interest rate ... There is another phenomenon, that is not a liquidity trap, but that can also create disinflation and even short-lived deflation. The phenomenon is a credit crunch. In a credit crunch credit becomes hard and/or expensive to come by, and this dampens the willingness to borrow, spend and invest. The difference between a liquidity trap and a credit crunch is that in a liquidity trap people have ample access to cheap credit and still choose to not borrow money, while in a credit crunch people do not borrow money either because they can't or because they view borrowing as too expensive. The basic attributes of these two phenomena are such that they are mutually exclusive. In a credit crunch you have limited access to cheap credit, in a liquidity trap you have ample access to nearly free credit; you can't have both.

I would beg to differ that one cannot have both as we are talking not only about interest rates are very different types of financial instruments but also about very different aspects of monetary policy. Our graphs are based on the monthly averages of interest rates on 20-year government bonds, AAA corporate bond rates, and BBB from January 1994 to December 2008. If we go back to 2001, it is interesting to note that the interest rate on BBB debt as of October 2001 was about the same as the interest rate as of January 2001 despite the fact that both AAA rates and rates on 20-year Federal bonds fell slightly. You may recall that this was the period where short-term rates fell dramatically but longer-term rates fell more modestly. But the big story was the climb in credit spreads – especially the BBB spread (BBB-s) which began in 2000 and continued through 2002. During the current recession, long-term Federal bond rates have fallen more dramatically but interest rates for companies with credit ratings of BBB or lower have increased as credit spreads have skyrocketed.

Traditional monetary policy can lower risk-free interest rates but recessions are also often associated with rising default risk. This recession in particular seems to have one of its underlying causes being increases in default risk and the associated troubles facing our financial institutions. Maybe this is why Ben Bernanke is frustrated with certain politicians not getting the need to release the remaining TARP funds:

This may be as close as we’re going to get to a Fed chairman labeling some in Congress as irresponsible. Sure, Federal Reserve Chairman Ben S. Bernanke was typically careful with his wording in a Jan. 13 speech in London. “The public in many countries” is “understandably concerned” that government is spending money to rescue the financial industry, “when other industries receive little or no assistance,” Bernanke said. After explaining how the world economy “is critically dependent on the free flow of credit,” Bernanke issued his challenge: “Responsible policy makers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest.” Three days after that speech, 33 of 39 Republican senators ignored Bernanke’s warning and voted against releasing the remaining $350 billion in Troubled Asset Relief Program money. (So did eight Democrats, mostly liberals, plus independent Bernie Sanders of Vermont.) Fortunately, that left enough supporters, mostly Democrats, to clear the release of the much-needed money. Too many senators shrugged their shoulders at Bernanke’s wise words.

As one of the fiscal stimulus critics that Greg Mankiw loves to cite, Gary Becker writes:

It is relevant in answering this question that the origins of this recession were in the financial sector, and especially in the excessive mortgage credit to sub prime and other borrowers. The widespread collapse of the financial sector, and the wholesale retreat from risky assets, clearly has called for a highly pro-active Fed. But it is not obvious why this should lead to greater confidence in the power of government spending stimulus packages. Of course, perhaps the prior emphasis on crowding out, and skepticism toward the stimulating effects of government spending, were wrong, or that recessions were too short and mild after the 1981-82 recession to call for Keynesian-type stimulus packages.

Becker has already been criticized for failing to note that interest rates were very high in 1982 but are nearly zero now. But he may indeed be right for the type of non-traditional monetary policy being advocated by our FED chairman today. Alas, many in the Republican Party are against both fiscal stimulus and this non-traditional monetary policy. I just don’t get it!

Update: Paul Krugman is kind enough to link to my post and then writes:

Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story. Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness. Yes, there are other things the Fed could do — and it’s doing them, on an awesome scale. But they’re controversial, precisely because, unlike conventional monetary policy, they involve picking and choosing among potentially risky investments. And there’s a much stronger case for fiscal policy than in normal times, because we don’t know how well these unconventional measures will work.

Might I add that I agree with Paul 100%!