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Some economists such as a Nobel Laureate Paul Krugman are of the view that if the US were to fall into a liquidity trap the US central bank should aggressively pump money and aggressively lower interest rates in order to lift the rate of inflation. This Krugman holds will pull the economy from the liquidity trap and will set the platform for an economic prosperity. In his New York Times article of January 11, 2012, he wrote,
If nothing else, we've learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it's a very real threat, and if and when it ends we should nonetheless be guarding against its return — which means that there's a very strong case both for a higher inflation target, and for aggressive policy ...(of the central bank).
But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?
The Origin of the Liquidity-Trap Concept
In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual's earnings.
Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.
For instance, if for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. Therefore, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.
A vicious circle sets in: the decline in people's confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.
Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates.
Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money, so it is held.
In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further.
This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people's demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply.
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.
Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects - what matters here is that a lot of money must be pumped, which is expected to boost consumers' confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby re-establishing the circular flow of money.
Do Individuals Save Money?
In the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this is seen as saving less.
Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed as saving more.
Observe that in the popular — i.e., Keynesian — way of thinking, savings is bad news for the economy: the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)
However, to suggest that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.
Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some point in the future).
Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer.
The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter so-called real economic growth.
Likewise, a change in the supply of money doesn't have any power to grow the real economy.
Contrary to popular thinking, a liquidity trap does not emerge in response to consumers' massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.
The Liquidity Trap and the Shrinking Pool of Real Savings
According to Mises,
"The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way."
As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and non-productive activities. Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than the amount it releases. This excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings.
This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real savings exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.)
Once the economy falls into a recession because of a falling pool of real saving, any government or central bank attempts to revive the economy must fail.
Not only will these attempts not revive the economy; they will deplete the pool of real savings further, thereby prolonging the economic slump.
Likewise, any policy that forces banks to expand lending "out of thin air" will further damage the pool and will reduce further banks' ability to lend.
Note that the essence of lending is real savings and not money as such. Real savings impose restrictions on banks' ability to lend. (Money is just the medium of exchange, which facilitates real savings.)
Also, note that without an expanding pool of real savings any expansion of bank lending is going to lift banks' nonperforming assets.
Contrary to Krugman, we suggest that if the US economy were to fall into a liquidity trap the reason for that is not a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings.
What is required in this case is not to generate more inflation but the exact opposite. Setting a higher inflation target, as suggested by Krugman, will only weaken the pool of real savings further and will guarantee that the economy will stay in a depressed state for a prolonged time.
Speaking on Bloomberg Radio to Kathleen Hays this morning, outspoken St.Louis Fed chair James Bullard dropped two somewhat shocking reality-check tape-bombs... that we are sure will quickly be rescinded and translated for the hard-of-understanding...
First, Bullard was aksed about concerns over a US economic recession. He began with the 'standard' response of any establishment type:
"I don't see any recession on the horizon."
But then, something got hold of him and he uttered the following omnipotence-threatening phrase...
"But you never know."
But, we thought you are supposed to know? Besides, aren't you and your cohorts responsible for pulling the strings of the centrally planned state?
While notable, howevever, it was his second 'oops' that shocked many.
Reflecting on the impact of unwinding The Fed's balance sheet, noting that it's effect was "almost nothing," Bullard decided to add the following:
"The Fed has been reluctant to target equity prices."
Which is a very different phrase from the usual utter denial from Janet Yellen or anyone else.
Did Bullard just admit that The Fed does 'tinker' with stocks... but reluctantly? Is this confirmation that like SNB, PBOC, and BOJ, The Fed manipulates the US stock market?
We're sure we'll never know, as if his comments are picked up by any other than the alternative media, it will be rapidly translated into doublespeak that confirms it means nothing.
* * *
And finally, as a bonus, Bullard admitted that "The Fed's inflation and growth 'misses' add up... and undercut credibility."
Which raises a simple question - what credibility?
Two weeks ago, the Securities and Exchange Commission declared that the virtual tokens issued during an initial coin offering, an increasingly popular funding mechanism for blockchain startups, are considered securities and are therefore subject to a l...
Authored by Jeff Thomas via InternationalMan.com, In the late 17th century, we British decided that, as a humanitarian effort and public service, we’d collect up all the people from the towns and countryside who were bonkers and confine them in i...
Brent Crude at 52.36, and WTI Crude Oil at 49.57 are testing the upper ends of their ranges of 48-53 and 47.60-50.50. My Bullish stance is unchanged ...
With the dollar index now 10 points below its recent cycle highs from early January, nervous dollar bulls are starting to reevaluate their initial assumption that this would be a short-term pullback, and many are worried that this could be the start of a new secular bear market. In this week’s MacroVoices podcast, host Erik Townsend invited two of the show’s most popular guests, Raoul Pal and Julian Brigden, two well-respected analysts whose research commands high fees from institutional investors, to discuss complacent equity markets, the timing of the next correction and whether US interest rates will “back up” another 50 basis points.
Townsend started by asking his guests to emphasize areas where they disagree to try and help listeners develop a better understanding of how the two analysts formulate their ideas about markets. But their discussion soon turned to the US dollar, which has been exasperating for the three longtime dollar bulls.
Pal admitted that the dollar’s persistent weakness was beginning to make him nervous as he's been losing money on his dollar trades for a dangerous stretch. However, he believes the “underlying basis for why the dollar bull market should still be in play” is still there.
“Raoul: My view, like yours, is bullish dollars. Now, the problem is we’ve only had two dollar bull markets in history, one in the early 80s and one in the late 90s. So we have a very small data sample to look at the behavior of dollar bull markets. But what I did notice is no dollar bull market has had a weekly close down more than 10%. Once it goes more than 10% it’s generally a reversal. So that’s a kind of—not so much a line in the sand but a guideline for me.
Now, we’re very much there now. We’re at 9.5% negative on a weekly basis. So it’s starting to make me concerned. There’s plenty of support levels around here as well. I use DeMark Indicators and they are counting towards a reversal. We know that the market positioning is very high. So for me it’s really crucial that the dollar does hold.
I think the underlying case for why the dollar bull market should still be in play is still there. But what we need is some sort of change of sentiment within the market, whether it’s either a renewed belief in much faster rate rises in the US or it’s weaker economic growth. The dollar has a kind of smile where it rallies in either/or but falls when we’re in the Goldilocks phase, which we’ve been having recently. So I’m looking at that.
I’m obviously nervous on my view because it has been going against me. And I’ve been in the trade for a long, long time now so, in Euro terms it’s about 148 and a half. So I’m now really finessing the idea does it move further than here?
If we look at the previous dollar bull markets they tend to go much further, so it would tend to suggest there’s maybe another 15 or 20% upside in the dollar over time. I also look at—and something we’ll probably talk about later—the comparison between this dollar bull market and the dollar bull market leading into the 90s is remarkably similar. The pattern almost fits exactly. And that was the period going into 1999 where we had a correction in the dollar. At that time it went about 8.5% and then it turned around and started rallying as economic growth started falling and rates started easing off a bit. The Europeans at the time were raising rates still. And that whole scenario, we saw actually the dollar go much, much higher. And so that’s what I’m looking for. If I’m wrong, the world’s a different place, and there’s a number of trade opportunities from that. But I still remain a dollar bull but a nervous one.”
Brigden says he remains a committed dollar bull, and sees the greenback rising in either one of two scenarios: the greenback will climb as equities and bond price fall in a "risk off rally" where the dollar becomes the haven asset. His other "risk on" case involves the dollar and stocks climbing alongside yieds. Hoping to avoid confusion with his fund's long-Europe trades, Brigden also said it's important to specify what exactly one means when they're talking about going long, or shorting the dollar.
“Julian: So I think one of the things—and I would concur pretty much with everything that Raoul said—I think one of the observations that I would make is that we’ve got to be a little bit careful of what we call a dollar. Because I think there’s a great temptation to look at some of the dollar indexes, in particular the Euro, and say, well, that’s indicative of what the dollar is doing. And I don’t really believe that is the case.
I think we have been as a shop very bullish, and I think it was on your show, Erik, talking about how we saw the growth pickup coming in Europe. We were singularly bullish, the dollar backing end of April beginning of May, for our clients—sorry, singularly bullish, Euro end of April beginning of May, for our clients. And that was on the break of—we started to see break above 108 in the Euro. In actual fact, we just advocated 24 hours ago to start taking profits in those long Euro positions.
But the point is that things like the DXY are essentially Euros. I mean, they’ve got some Swiss Francs in there, some Swedish Krona, and those are both pegged effectively to the Euro. So you really, I think you have to be a bit careful.
I think what we’ve seen a lot this year is a repricing of the growth-inflation story in Europe. And I think that’s one of the reasons why the dollar has been underperforming. So I’m not quite as concerned about this 10% line in the sand. I think Raoul makes some good observations on that, but I would say that I think to get the next kicker we need to see some developments in story here in the US.
We’re either going to have to see a—and this is my fear—we’re going to see a risk-off dollar rally. So you could have a situation where you can get a correction in bond markets and a correction in equities, and you can actually get the dollar rising because it’s a safe haven vehicle. Or we move into the latter half of the year, we get the Fed to start to shrink the balance sheet—I talked to your listeners about this before—I think that’s potentially a very bullish event. And particularly as well in early 2018 if we get the Trump tax cut.
And my sources in D.C. tell me that still the odds—even though Trump doesn’t seem to be able to put his trousers on straight any day of the week—that the odds are somewhere around 65-70% that we get a tax deal. And it will definitively include repatriation. So I think, to me, I’m still in that structural bull environment for the dollar. But it—we may have quite a few months to wait still. And in that interim, I think what we’re doing is just repricing the Euro.”
Turning the conversation to equities, Brigden said the US market is showing signs of a "classic bubble," meanwhile, rising interest rates and a hoped-for reversal in the dollar would remove two of the fundamental cases for being long equities.
“Just because we’d had this incredibly good run, we think that a lot of the outperformance of the European stock market had been predicated on Euro weakness and also low bond yields. And both of those we think are in the process of changing. So we scaled back our belief in this European outperformance trade at this stage.
I think the US equity market, we seem to be going through this game of rotation. And once again, to differentiate between markets, you know, in the same way that you can’t look at the dollar as just a single thing. What we’ve got is we’ve had up until the last week or so really very aggressive outperformance by a relatively narrow group of stocks. And those stocks—and you know we’ve talked about it in a number of publications—are increasingly looking like what I would call a classic bubble, and I think I’ve talked on your show about a classic bubble. It’s just chart pattern we look for, Erik.”
Meanwhile, Pal said “there are opportunities” in equities among the ongoing changes in underlying market conditions:
“Raoul: Well, for me, I would like go back to the business cycle. You know, we looked at it last year and the business cycle weakened significantly, gained traction again, and bounced again. I mean, it’s done this a couple of times now. It’s tiresome, but it is what it is. Because I much prefer it when we get to the bottom of a cycle—we know when to invest etc. But waiting for this is slightly painful.
But until economic growth weakens in any meaningful way, the equity market will continue to grind higher, volatility will remain low, until something changes. Now there is—and that’s structural volatility. There are opportunities—and I think Julien will talk a bit about this—for spikey volatility where there is an opportunity for a risk-off, which may not be pervasive and may not last very long. We won’t get anything that lasts long and we won’t get a structural shift in volatility until the business cycle weakens.”
Pal also believes that interest rates could head back toward 3% in the medium term if President Donald Trump manages to pass tax reform.
“Raoul: Yeah, again, we need to talk about path and we need to talk about time horizons. So, for me, the path is—I’m less interested in—I think it’s a pretty benign environment for US rates. Yes, if Trump does manage to pass something in terms of economic stimulus in terms of some sort of fiscal policy or taxation, whatever it may be, then can rates back up a bit? Yeah.
But, for me, I’m indifferent from a backup in rates from, you know, 225 where they are today at ten years, to, 275. Fifty basis points I don’t really care, because I think the risk reward is that, at the bottom of the business cycle—which we’ve identified has to come and will come within the next call it 18 months—the bottom of the business cycle should see bond yields at 50 basis points or even less. So that makes, even with a backup in yields to let’s say 275, it still makes it kind of a five for one risk reward.
So, for me, I look through the speed bumps and look at the horizon. The horizon for me is 50 basis points at the bottom of the next business cycle, which has to come. Well, it doesn’t have to come, but the probability is extremely high that it comes in the next 18 months or two years.”
Brigden said that while Pal may be correct, he wasn't comfortable with the time frame, saying it could take longer for bond yields to start moving higher again. But the more important question is when will we see the next market crisis commence, and how will we get there. That's the key topic of discussion in the next section:
“Julian: Yeah, it is Erik. I mean, it’s certainly in the next, shall we say, six months. And I think it’s—Raoul and I talk about this a lot and it’s one of the things that I think we believe is one of the strengths of the product: we tend to sort of chew through our stories. And our views are structurally very, very similar, but often our timelines are slightly different in how we get there.
And my concern is I can ultimately see Raoul’s right, I mean, I think we could get another very nasty downturn. I think we could get a—you know, it’s hard to argue against the sort of structural deflationary trends or disinflationary trends that you see globally. The question is how do you get to that next crisis? Do you sort of go quietly into the night, and we walk in one day and ISM stands at 45, and everybody says, wow, QE doesn’t work. Or do you get there a different way?
And my inclination is I believe we’ll actually get there a slightly different way. And at the moment the biggest risk that I see in markets is this chasm between, as I said, equity market pricing and bond pricing. And with that you can throw in Vol. And my biggest fear is that we’re going to get to the next crisis, not via immediate economic weakness, but actually via strength.
And it isn’t so much in the US. As I said, I think there’s a chance that we get a burst of very aggressive activity. That’s sometime in 2018 if we get this Trump stimulus through.
But when I look at the world, actually, my biggest fear—and I think this is interesting for US listeners of yours, because generally Americans don’t look too broadly at the rest of the world, they tend to be very focused certainly in financial networks, they tend to be very focused on what’s going on in the US—I actually think the biggest risk is Europe. I look at European growth models—and we’ve talked about this—but these things continue to strengthen. And the inflation picture, actually, I think is just really going to rip.
And I was reading today how one of my peers was talking about how, for the fourth time, ECB’s going to have to upgrade their growth forecasts. Well, I just think they’re going to have to keep upgrading and upgrading their growth forecasts. And what I fear is that we’re on the cusp of a repeat of events that we saw in the spring of 2015. So, if you remember, at that point ECB had launched QE in the end of 2014, the DAX had ripped higher, and bund yields were locked at zero. And then, one day we walked in and the bund market finally said, screw this, I am repricing because what’s the point of holding bunds at zero, if the DAX is going through the stratosphere.”
Both men are also worried about how shifting demographics, notably how the aging baby boomer generation will impact markets. With the largest-ever wave of retirees set to leave the workforce in the next few years, equity markets are facing a terrifying transition: When millions of buyers are, for the first time, forced to sell.
You can listen to the podcast in full below:
While all eyes have been focused on the incessant rise in the price-weighted farce known as The Dow Jones Industrial Average, a funny thing happened in the 'real' market...
The S&P 500 went nowhere... 2474, 2473, 2473, 2470, 2477, 2478, 2475, 2472, 2470, 2476, 2478, 2472, 2477...
How unusual is this? Simple - it's never, ever (in 90 years of S&P history) happened before...
Since The Fed (et al.) began tinkering (red shaded box), markets have slowly (and now quickly) died.
Perhaps even more worrisome, Investors are positioning for more of the same...
There has never been a bigger speculative position tilted towards still-lower volatility...ever!