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Sunday, April 01, 2012

McCulley: Monetary and Fiscal policy must be "irresponsible" in a liquidity trap

by Calculated Risk on 4/01/2012 09:45:00 AM

I've been reading former PIMCO managing director Paul McCulley for years (great insights). The following piece discusses the current liquidity trap and the failure of austerity in Europe: "Fiscal austerity does not work in a liquidity trap and makes as much sense as putting an anorexic on a diet."

From Paul McCulley and Zoltan Pozsar: Does Central Bank Independence Frustrate the Optimal Fiscal-Monetary Policy Mix in a Liquidity Trap? (ht Richard)

An excerpt:

The United States and much of the developed world are in a liquidity trap. However, policymakers still have not embraced this diagnosis which is a problem as solutions to a liquidity trap require specific sets of policies. There are policies that will work, and there are policies that will not work. Correct diagnosis is necessary to prescribe the right policy medication.

A liquidity trap is a circumstance in which the private sector is deleveraging in the wake of enduring negative animal spirits caused by the bursting of joint asset price and credit bubbles that leave private sector balance sheets severely damaged. In a liquidity trap the animal spirits of the private sector cannot be revived by a reduction in short-term interest rates because there is no demand for credit. This effectively means that conventional monetary policy does not work in a liquidity trap.
This is not to say that the private sector should not deleverage. It has to. It is a part of the economy’s healing process and a necessary first step toward a self-sustaining economic recovery.

However, deleveraging is a beast of a burden that capitalism cannot bear alone. At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.
[McCulley reviews several recent cases]
These historical cases of acting responsibly, irresponsibly and half-heartedly irresponsibly relative to orthodoxy carry telling lessons for the outlooks of the Eurozone, U.K. and U.S. today.

First, acting responsibly relative to orthodoxy in the Eurozone and following the German “dictat” of sado-fiscalism and internal devaluation are reminiscent of several defining economic episodes and frictions of the interwar gold standard.
On a more systemic level, Germany’s refusal to inflate at the core while insisting on internal devaluation in the periphery is eerily similar to the frictions caused by the imbalance between gold surplus countries refusing to inflate and deficit countries unable to sufficiently deflate during the 1920s and early 1930s.

Just as laboring classes could not bear the pain of adjustments required by the gold standard’s orthodoxies, laboring classes in peripheral Eurozone economies may not be able to bear the pain of adjustments required by the single currency’s orthodoxies.

If history is our guide, painful adjustments will ultimately lead to some countries abandoning the euro, or politics overruling monetary orthodoxies: (1) legal restrictions against monetizing debt today versus the fixed exchange rate mentality of the gold standard, and (2) the independence of the ECB.
Second, acting responsibly relative to orthodoxy on the fiscal front, but acting irresponsibly relative to orthodoxy on the monetary front, policies in the U.K. are also unlikely to work.
Third, to date, the U.S. has acted irresponsibly relative to orthodoxy on both the fiscal and monetary front. This is good.

However, risks are rising that while the monetary authority will remain committed to acting irresponsibly, the government will choose to act responsibly relative to fiscal orthodoxy and adopt austerity.
I agree with McCulley that most of the world is in a liquidity trap and it appears that austerity alone will eventually fail at the ballot box, see from Reuters: Resistance to Austerity Stirs in Southern Europe