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Wednesday, December 24, 2008

Past as Prologue for the Financial Bailout

Over the coming weeks, we are going throw hopefully more light than heat on the managers of the Bailout by taking a journey through the basics of economic conditions that create such situations requiring strong intervention into the economcy. We start out with some macroeconomic concepts essential to the problem.

LIQUIDITY TRAP. In a trap, money injected into the economy through an open market has no stimulative effect because it is hoarded either by banks as excess reserves or as cash “under the mattress” as precautionary or emergency balances by households or business (2008 companies drawing on lines of credit). In a 100% trap, all increases in the monetary base would be “hoarded” for whatever reasons (and finding the reasons is important for remedies). St. Louis Fed plots of borrowed reserves, excess reserves, and the monetary base for 2008. With no trap and no Fiscal distortion the base Ba, M1, and borok credit should change proportionally. In a half trap, Ba would expand twice as fast quarterly to counter the 50% hoarding effect.

PUSHING ON A STRING. There is an idea known as a liquidity trap. See Keynes (1936) and most macroeconomists since. There is an argument over the existence of liquidity traps. If traps do not exist, then we do not need to worry about getting out of them, but if there are traps (1935?, Japan, USA 2008?)

In a Federal Reserve article, Orphanides ( 1993) argues that 1934-6 depression was not a liquidity trap. The contention of whether there is a trap or not is too narrow. There may be a partial trap, the analogy being loose steering of a car. There may be “play” in the steering wheel but if turned enough the car will change direction.

The approach to be used here could be called the “Deep Throat” approach – “Follow the Money” (Hal Holbrook in All the President’s Men). In a trap, base money injected into the economy through an open market has no stimulative effect because it is hoarded either by banks as excess reserves or as cash under the mattress by the nonbank public. We will track what happened to the monetary base, Ba, and components (currency in circulation and reserves) with data from the Federal Reserve Bank of St. Louis website in 1934-6 and draw analogies to today's situation.


Blogger Adam Smith said...

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Adam Smith, Karl Marx, John Maynard Keynes and Alan Greenspan: a Unified Perspective


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In This Age of Turbulence People Want an Exit Strategy out of Credit, an Adventure in a New World Economic Order.

Read It.

6:40 AM  

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