Rational Irrationality: The Stimulus Debate: I’m with Larry (and Keynes) : The New Yorker

If you're like me, you vaguely remember the term "liquidity trap" from your econ class at college.

Last seen in this country during the 1930's, a liquidity traps occur in economies where the banking system is awash with cash that they either refuse to lend or no one wants to borrow. In this relatively unusual economic period, monetary policy becomes fairly ineffective, since additional liquidity from the central bank doesn't provide any additional stimulus.

John Cassidy - a writer for The New Yorker - believes that the U.S. is either close to a liquidity trap or mired in one already, which makes any traditional tools that the Federal Reserve essentially useless.

As he writes:

With interest rates at close to zero, banks reluctant to lend, and many businesses and households hoarding cash because they are too nervous to invest it, monetary policy—the other tool the government can use to stimulate the economy—loses much of its effectiveness. As {White House economic advisor Larry}Summers points out, the U.S. economy is now in, or close to being in, what Keynes referred to as a “liquidity trap,” where a Fed-inspired expansion of the money supply has little impact.

Now, liquidity traps, which economists used to consider historic relics, are not at all pleasant to experience. In many cases, they are associated with falling prices and extended periods of economic stagnation. (Ask the Japanese, who have been trapped in one for close to twenty years.)

Sufficient to say, this is a very challenging time to be an investor. The stock market continues to be choppy as the investment community digests second quarter earnings. Earnings comparisons, by the way, will become more difficult in the next couple of quarters, since the economy had begun to rebound slightly in the second half of 2009.

On the other hand, for investors looking for yield, the stock market is becoming the place to invest, particularly in consumer staples and utilities sectors. Recently we have seen two bond issues where the yield on the stock is nearly 50% more than the yield on a bond issued by the same corporation - and yet investors gobbled up the corporate bond.

The bond market offers very little value except for longer maturity notes. For example, as I write this note, the 10 year Treasury note is yielding 2.88%, while the 2-year Treasury is 0.50% (an all-time record low). Muni rates are also low - you have to go out at least 7 years to get a yield above 2%.

Liquidity traps are no fun.

Rational Irrationality: The Stimulus Debate: I’m with Larry (and Keynes) : The New Yorker