Monday, January 26, 2009

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%!


TheTrucker said...

What we are seeing is the failure of the misdefinition of capitalism. If one applies the classical definition of capital to the word "capitalism" it is pretty easy to see the error.

Long ago in the Land of Nod there was a definite correlation between money and gold doubloons. And though there was and is no definite link between the value of these doubloons and labor or commodities, the money did have a labor component and was not simply created on a keyboard at the Fed. It was therefore possible to include money in a broad definition of "capital" where "capital" was that produced by labor and then not consumed but instead used to facilitate production and trade. Succinctly, money was earned. It was not just created.

I am not a "gold bug" and I do not propose that money should be backed by gold or any other commodity. My point is only that we have allowed "capital" to become "credit". So the system we have might better be called "creditism" as opposed to "capitalism". Any silly notion that a "credit" system is free market "capitalism" is an exercise in lying. Our current system anoints the controllers of credit with the power of kings and "capital" (trucks, trains, and areoplanes) plays second fiddle.

If I was going to have a system of credit and money I would try to achieve what the Fed was suppose to achieve in the first place: A credit system that could grow and shrink according to the real demands of the underlying economy. But in order to do that successfully it is necessary to project the actual productive capacity of the economy in such a way as to guard against overspeculation. This actally gets right back to Glass-Steagall and those walls between the commercial banking system and the financial sector. So long as the commercial banking system is solid and so long as the productive enterprises are financed through the commercial system then the economy is relatively secure. Such a system does not prevent a "financial sector" from speculating and from amassing large returns to risk. The commercial system would benefit from the success of the more risky "investment banking" system (jobs and production) while not being dependent on it. There is no way that "investment banking" should be involved in financing home mortgages. There should have never been any "securitization" of home mortgages because such "loans" are not investments in _real_ capital.

The Fed should control the commercial banking system and the SEC and the CFTC should control the "financial sector". The "financial sector" should be allowed to fail while the commercial banking system should be rescued. The Congress is responsible for all of these control organizations. The Congress can "un-create" the Fed tomorrow and recreate it the next. So too can the Congress control the SEC and the CFTC. The failure we are seeing is because the Congress failed. And the Republicans continue the march toward the unitary executive as the aristocrats seek to consolidate more and more power in as few hands as possible.

Anonymous said...

You Bail Them Out, We Opt Out. We Want Some TARP

Dear, I should say Expensive Chairman Ben S. Bernanke,

All of Our Economic Problems Find They Root in the Existence of Credit.

Out of the $5,000,000,000,000 bail out money for the banks, that is $1,000 for every inhabitant of this planet, what is it exactly that WE, The People, got?

If my bank doesn't pay back its credits, how come I still must pay mines?

If my bank gets 0% Loans, how come I don't?

At the same time, everyday, some of us are losing our home or even our jobs.

Credit discriminates against people of lower economic classes, as such it is unconstitutional, isn't it? It is an supra national stealth weapon of class struggle.

Credit is a predatory practice. When the predator finishes up the preys he starves to death. What did you expect?

Where are you exactly in that food chain?

Credit gets in the way of All the Principles of Equal Opportunity and Free Market.

Credit is a Stealth Weapon of Mass Destruction.

Credit is Mathematically Inept, Morally Unacceptable.

You Bail Them Out, We Opt Out

President Bush Proposed the TARP, Senator Obama Voted It.

We Want Some TARP.

Opting Out Is Both Free and Strictly Anonymous.

My Solution: The Credit Free, Free Market Economy.

Is Both Dynamic on the Short Run & Stable on the Long Run, The Only Available Short Run Solution.

I Am, Hence, Leading The Exit Out of Credit:

Let me Outline for You my Proposed Strategy:

My Prescription to Preserve Our Belongings.

Our Property Title: Our Free, Strictly Anonymous Right to Opt Out of Credit.

Our Credit Free Money: The Dinar-Shekel AKA The DaSh, Symbol: - .

Asset Transfer - Our Right Grant Operation - Our Wealth Multiplier - Our Liquidity TARP.

A Specific Application of Employment, Interest and Money.
[A Tract Intended For my Fellows Economists].

If Risk Free Interest Rates Are at 0.00% Doesn't That Mean That Credit is Worthless Already?

Since credit based currencies are managed by setting short-term interest rates, on which you have lost all control, can we still say that are managing?

We Need, Hence, Cancel All Interest Bearing Debt and Abolish Interest Bearing Credit.

In This Age of Turbulence The People Wants an Exit Out of Credit: An Adventure in a New World Economic Order.

The only other option would be to wait till most of the productive assets of the economy get physically destroyed either by war or by rust.

It will be either awfully deadly or dramatically long.

A price none of us can afford to pay.

“The current crisis can be overcome only by developing a sense of common purpose. The alternative to a new international order is chaos.”

- Henry A. Kissinger

What Else?

Until We Succeed the Economy Will Necessarily Keep Sinking Into a Deeper and Deeper Depression

You Bail Them Out, Let's Opt Out!

Check Out How Many of Us Are Already on Their Way to Opt Out of Credit.

If You Don't Opt Out Now, Then When Will You?

Let me provide you with a link to my press release for my open letter to you:

Chairman Ben S. Bernanke, Quantitative [Ooops! I Meant Credit] Easing Can't Work!

I am, Mr Chairman, Yours Sincerely [As if I really had the choice.],

Shalom P. Hamou AKA 'MC-Shalom'
Chief Economist - Master Conductor
1 7 7 6 - Annuit Cœptis
Tel: +972 54 441-7640
Fax: +972 3 741-0824

Anonymous said...

Since you make a comment about my entry I wanted to let you know that I have written a new entry on the subject here

TheTrucker said...

I am not yet done with this.

There is another point that it is less obscure than the proper distinction between money and capital and it has to do with these arguments over "liquidity trap". I just happen to think that investments in such labels as "liquidity trap" are foolish and that these lead to the current Mexican standoff between idiotologies.

And while it is true that properly measured "employment" (i.e. a measure of the opportunity to acquire "stuff" or "leisure") is a valid yardstick in all political economy, this distinction between whether or not such opportunity is being offered up by the public or private sector forms the "religious" portion of the standoff. In reality "opportunity" does not tarnish or degrade based on its origin. It is of no consequence as to the fountain from which such opportunity might flow. If "full employment" is the maximization of opportunity then that is the goal of proper political economy. Arguments over whether the "private sector" is having to pay higher wages are, to me, a typical exercise in Republican plutocracy. What actually matters is opportunity and it is measured in wages. Any control of the economy that is not in the sustainable best interest of wage earners is economically perverse.

Randeg said...

I hear your scholarly discussion on the liquidity trap which I understand now more clearly due to your explanation. But what I cannot understand is why the lawmakers will approve the bailout money to the banks and the big corporations and some of that money even banished into thin air. At least that's what I heard last on the matter and yet these lawmakers will give a hard time on granting the bailout money to those who need it most like creating jobs for ordinary people.

Evelyn Guzman (If you want to visit, just click but if it doesn’t work, copy and paste it onto your browser.)

rate said...

To solve this crisis, authorities should find a balance for interest rates, that could help both consumers and financial institutions. Otherwise, one of the parts will face bankruptcy.

rate said...

Moreover, citizens should be more aware of how the crisis can affect them and take some action in this direction.