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A Guide to the Gold Standard

7 Jul

April 1933, the US goes off the gold standard


The temporary suspension of the gold standard turned out to be anything but temporary, which reminds me of a Milton Friedman quote, “Nothing is so permanent as a temporary government program.”

The purpose of this post is to show that it is technically possible to implement a gold standard today. Many criticisms against the gold standard claim that it is not possible to shift to a gold standard. These criticisms range from – the money supply will fall, there will be chaos if many agencies control money supply, there is not enough gold in the world to shift to a gold standard. These criticisms are baseless and betray an understanding of what money really is.

Once we have clarified  (hopefully) that it is technically possible to implement a gold standard, whether we should shift to a gold standard is an altogether different question. So, the way to argue against the gold standard is to debate along ideological lines. If someone argues that we should not implement the gold standard because the government should control the money supply, that’s fine. The nature of the debate then  boils down to whether the government should control the money supply or not. However, if one argues against the gold standard saying that it is not possible to implement the same, the debate does not stand any merit.

I myself am guilty of the same misunderstandings that I attempt to clarify through this post. On 4 December , 2010, I had put a post in this blog with the title In defense of fiat moneyMuch of what you will read in this post will directly contradict what was argued earlier.

What is so special about gold?

First and foremost, the Austrian economists do not support the gold standard because it has some mystical properties. As our economy moved from barter to exchange based on money, gold came to be widely accepted as the best medium of exchange. This was because gold satisfied the many qualities of a good medium of exchange, like acceptability, durability, portability, homogeneity, scarcity.

Murray Rothbard in his book, What has the government done to our money, says

Historically, many different goods have been used as media (medium of exchange): tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks. Through the centuries, two commodities, gold and silver, have emerged as money in the free competition of the market, and have displaced the other commodities.

Thus, the Austrians support the gold standard as gold is what the market accepted as money before the government monopolized the money supply. It is not for any economist to decide what commodity should be used as money. Our monetary history suggests that gold was established by the market as the best form of money. In case some other commodity had been established as money, we would have been arguing for a monetary system based on a different commodity.

What is the Gold Standard?

Simply put, a gold standard means a monetary system based on the commodity gold. Does this mean you will have to carry gold bars in trucks to make payment for buying real estate? No. You can make payments in paper receipts which will be redeemable in gold. Who has the obligation to redeem the paper receipts for gold? Obviously, the entity who has issued the receipts; which brings us to a very contentious question – who has the right to issue such redeemable paper receipts?

In a gold standard, anybody who has gold can issue such receipts. Suppose the government has gold reserves of 1 tonne. It can issue its own paper receipts, say the ‘dollar’ and define it as equal to 1 gram of gold. This will allow the government to issue 1 million dollars. Similarly, anyone can take out their own paper receipts. If you have 1 tonne of gold, you can take out your own receipts, and label it ‘rupiya’ and define it as 1 kg of gold. This will allow you to print 1000 rupiya. You can take this rupiya to the market and buy goods and services.

Will the market accept your rupiyas as payment? That will depend on your credibility in the market. Say you went to purchase a car and it costs 1 kg gold. You can use your one rupiya to buy the car. The car dealer can later knock at your door and ask you to redeem your one rupiya for 1 kg gold. If you do not redeem your rupiya, your credibility declines, and in the future, market participants may refuse to accept rupiyas.

Does this mean you will starve to death with nobody willing to sell you food? Of course not. Even if the credibility of your rupiya has gone for a toss, you can always turn in your gold to the government and receive dollar in exchange. Or you could turn over your gold to a bank whose currency is widely accepted by the public. Or, you could simply melt your gold into smaller units and use it directly for exchange.

The point I am trying to make here is that in a free market gold standard, the market will decide the paper receipts or currency that will be used. Will there be multitude currencies and chaos? No. History suggests that the market will eventually settle to a few different types of paper receipts. Maybe, only dollars will be used or maybe, currencies issued by certain trust worthy banks will be used. (It may be mentioned here that currency issued by different banks will not be a problem, just as having savings account at different banks is not a problem. Inter bank transactions can take place through a clearing house, as is presently done.)

Paper currency issued by different participants in the gold standard are simply receipts for a claim towards gold. As gold is the real money in a gold standard, we stumble on an important question. Who has the right to mine gold? Well, no points for guessing, but obviously the Austrian reply to this question will be – its a free market, everybody has the right to mine gold.

Suppose you want to buy a car, which costs 1 kg gold. You have two choices – either you can mine 1 kg gold and pay for your car, or you can choose to work somewhere and get 1 kg of gold as wages. Which option you choose depends on which activity will demand the least effort from your side – this is similar to saying which activity is preferable to you. Similary, a mining company will mine gold till the time it is profitable for it to do so. It may seem that in a gold standard, private  mining companies will earn super normal profits and will become masters of the universe. This is not true.

An example will clarify.

Assume a mining company can hire laborers for 1 kg gold per day to work on its gold mines, and each laborer can mine 5 kg of gold per day. Can such a situation arise in a free market? Of course not. Why would anyone accept 1 kg gold in payment for extracting 5 kg of gold? One can argue here that independently (without machinery of the mining company), the laborer will be unable to mine gold, and hence he may accept a lower payment that the value of gold he produces. Even then, what prohibits another company which can buy machinery and hire laborers to start mining operations? Eventually, as long as mining gold remains a profitable activity, the supply of gold will keep on increasing, adding to the existing supply of gold stock in the economy. Eventually, the “price” of gold (in terms of its purchasing power in buying goods and services) will fall to match the cost of extracting gold and we reach a sort of “steady state” supply of gold.

As we can see above, the supply of gold, which is to say the supply of money in a gold standard, is determined by the market. It is important to mention here that the initial stock of gold, as well as the addition to gold stock through mining, are irrelevant from the point of view of operation of the gold standard.

We can take a stylized example of an economy to understand the above point.

Assume an economy which produces only one good – say 1000 units of X. Assume the initial stock of gold in this economy is 1000 kgs and gold is the accepted medium of exchange. This 1000 kgs of gold is split between two market participants, say A and B, equally – 500 kgs each. What will be the price of one unit of X in this economy? X will cost 1 kg gold, and both A and B can buy 500 units each of X. Now, in the same example, assume that the initial stock of gold, which is split evenly between X and Y, is 1 kg. The price of one unit of X will be 1 gm and A and B can both still buy 500 units each of X. Now assume that because of a certain technological innovation, it has become easier to mine gold and the stock of gold in the economy increases to 2000 kgs. Ceteris paribus, the price of one unit of X increases to 2 kgs of gold and A and B can both still buy 500 units of each.

In a fiat money economy, the way to think about this is to imagine that one morning when you wake up, you are told that an extra “zero” has been added to all monetary denominations. So Rs 10 is now Rs 100. What used to cost Rs 10 before will now cost Rs 100. Similarly, if you were earning Rs 10 before, you will now earn Rs 100. In real terms, nothing changes. By adding an extra zero, we have increased the monetary base in an economy ten times. If the initial stock of money in an economy was Rs 10 lakh, it is now Rs 100 lakh. In real terms, nothing changes. In nominal terms, the purchasing power of rupee has fallen – what you could previously buy with Rs 10 will now cost Rs 100.

What is important is real consumption of goods and services. Money is simply used to exchange goods and services. If there is a huge initial pile of gold, prices will be quoted in tonnes or million tonnes. If we have very limited supply of gold, prices will be quoted in grams or milligrams. We can use any unit we want, it couldn’t matter less.

Can we shift to a Gold standard today?

Yes we can. Most of the criticisms against the gold standard have already been addressed above. We saw how in a free market gold standard, even though everybody has the right to issue currency, there is no chaos or dooms day. The market will choose as currency the paper receipts which have the highest credibility for redemption in gold. In fact, the term ‘dollar’ originated from coins which earned a reputation for their quality.

Murray Rothbard in his book, What has the government done to our money:

The dollar began as the generally applied name of an ounce weight of silver coined by a Bohemian Count named Schlick, in the sixteenth century. The Count of Schlick lived in Joachim’s Valley or Jaochimsthal. The Count’s coins earned a great reputation for their uniformity and fineness, and they were widely called “Joachim’s thalers,” or, finally, “thaler.” The name “dollar” eventually emerged from “thaler.”

We also saw how the initial stock of gold or increase/decrease in supply of gold pose no difficulties in the technical operation of the gold standard. These are not merely assertions but facts that can be verified by studying monetary history.

Though we have implicitly addressed the criticism that there is not enough gold to shift to a gold standard, lets discuss this again through an example.

Assume an economy is running on gold standard. The gold reserves in this economy is 1000 kg and a dollar is defined as 10 kg of gold. Thus, there are 100 dollars in this economy. Now, the government abolishes the gold standard and monopolizes the function of issuing currency in the economy. With the link between the dollar and gold reserves broken, the government is now free to print dollars without any corresponding increase in gold reserves. Ten years later, the supply of dollars in the economy has increased to 1000 dollars.

If the government wants to re-introduce the gold standard, with the initial stock of gold reserves (1000 kg ) and the inflated supply of  1000 dollars, the dollar will have to redefined from being equal to 10 kg of gold to 1 kg of gold. We can shift back to the gold standard with the same initial gold reserves but an inflated paper money supply. The question of insufficient gold reserves does not arise. Ludwig Von Mises had remarked that an ounce of gold is sufficient to run a gold standard. I think we can appreciate the significance of this quote in the context of the above example.

We now need to address a final point before closing this post. Lets continue with the above example.

Before the government redefines the dollar as being equal to 1 kg of gold, the “price” of gold observed in the fiat economy will be lower than this rate, i.e., the dollar will be overvalued and gold undervalued. This is to be expected as under a fiat money system, the supply of dollars increase as a much faster rate than the supply of gold reserves. Gold has to be mined from the depths of the earth while money can be printed in bulk effortlessly. In our example, assume the price of gold in the fiat economy is half a dollar for 1 kg of gold. This creates a confusion that we need  2000 kgs of gold to convert the 1000 dollars into gold and shift to a gold standard. Since the gold reserves are only 1000 kgs, there must be “insufficient gold.” As we have seen, this betrays an understanding that money is not an independent entity, but a unit of account. The dollar simply has to be redefined to “equate” the available gold reserves with the existing supply of paper money.

When the government redefines the dollar as 1 kg of gold, immediately we see that gold has “appreciated” and the dollar has “depreciated.” 1 kg of gold previously used to fetch you half a dollar. After the introduction of the gold standard and the redefined dollar, 1 kg of gold will fetch you 1 dollar.

If you are a gold mining company (or individual) and were previously selling a kg of gold for half a dollar, you can now exchange the same for one dollar. If it was profitable to sell a kg of gold at half a dollar, its two times more profitable to sell a kg of gold for a dollar. This will lead to more companies (or individuals) engaging in gold mining. This process will continue until rampant mining bids up the cost of gold mining to such an extent that the profit return on gold mining falls to the return observed in other industries. The laws of normal profit which apply to any other industry in a free market economy will apply in the mining industry too.

Why did the Gold standard collapse?

If indeed the gold standard is a workable solution, why did it collapse? To answer this question, we will have to take a voyage through the monetary history of the world. We can keep this topic for a future blog post. Suffice it is to say here that the gold standard did not meet its demise because of any inherent flaws.

Indeed, the gold standard did not collapse – it was abandoned by the government.


A single blog post cannot do justice to a topic as wide as monetary systems. I intend to write more on this in the future. In case you are not convinced regarding some points or feel that more clarity is required, please feel free to drop a comment and I will try to elaborate further.


What the bond yield tells us…

13 Mar

Bond yields always tell a nice story. Have a look at the graph below,

In 1Q2010, the 10 year US government bond yield was in excess of 3.5%. A higher long term bond yield can indicate optimism about the heath of an economy. There are several hypothesis for the same, one of them being that interest rate on long term bonds contains information about future short term rates. A low long term interest rate is an indication of lower short term rates. Short term interest rates are low in a recessionary economy, as an economy in downturn is characterized by low inflation. Also the monetary authority of a recessionary economy will hold down the interest rates as part of a counter cyclical monetary policy. Going by this logic, in 1Q2010 , investors were generally sanguine about the growth prospects of the US economy. This is also confirmed by the rally in S&P  500 between February and May 2010.

The rally in developed markets (DM) helped lift sentiment in emerging markets (EM) with the iShare MSCI EM exchange traded fund gaining in the same period. MSCI EM is a benchmark used to monitor equity performance in emerging markets. Since histroical price data for this proprietory index is not publicly available, I have used the performance of iShare MSCI EM exchange traded fund which tracks the MSCI EM index.

In 2Q2010, structural issues in developed economies came to the front. The burgeoning US government debt and sticky unemployment figures spooked markets. Combined with the sovereign debt crisis in the Euro region, a bear market set in. The 10 year yield fell from a high of 4% to 2.4% in October 2010 and the S&p 500 also corrected during the period. Out of investor fear in developed economies, a rotation trade started with investors pushing up EM equity at the expense of DM equity. The iShare MSCI EM ETF gained around 25% in 2Q2010.

Then came October 2010 and everything changed. Just when investors had written off DM equity as an asset class, the mood suddenly turned bullish. There was widespread expectations of a second round of quantitative easing by the Fed and the investors started pricing that towards the close of 2Q2010. As expected, the Fed announced an asset purchase policy of US$600 bn on November 5th. The 10 year yield rallied close to a high of 3.8% by February 2010 and the S&P500 returned 15% in the the 5 months since October 2010. And yes, the rotation trade reversed with EM equity under performing DM equity. Investors were beginning to get concerned with rising inflation in emerging markets in 3Q2010. This coupled with the better outlook of the US economy took the sheen off equity markets in EM.

If you read my previous post ‘The real motive behind QE2‘, I had mentioned  that an asset purchase policy should lead to a fall in yields as the government buys back bonds, pushing up their prices and lowering yields. This was also the official reason given by the Fed for the asset purchase programme – to lower long term borrowing costs. The exact opposite happened. Bond yields soared. However, nobody was complaining as the higher bond yields were interpreted as improving outlook for the US economy.

Now, where are we in March 2011. If you look at the graphs, you will see that the bond yield is now falling and the S&P500 is correcting. Does this herald an end of the QE2 backed short term optimism? If the mood turns bearish, will there be another QE3? Will the weakness in DM equity bring down EM equity with it? Or will a rotation trade emerge with investors moving money from developed markets to emerging markets?

All questions worth pondering on…


13 Sep

US Government Deficit - Historical

President Barack Obama released a budget plan that expects the federal deficit for 2010 to be a record $1.56tn, surpassing last year’s record of $1.4tn. That translates to a fiscal deficit of 10 per cent to the GDP. The US debt-to-GDP ratio already stands at 93 per cent.

How will this debt be financed? Lets delve deeper into this.

First the basics. Suppose the US government budgets for an expenditure of USD 100, but its revenues (through taxation and other sundry revenue sources) are only USD 90. This entails a budget deficit of USD 10, which is financed through borrowings. The Treasury issues bonds of face value USD 10, and makes good the deficit.

The buyers of the US government bonds can be classified under three heads- private investors, foreign central banks and the Federal Reserve. Private investors include private retail investors (this forms a very small proportion) and private institutional buyers (like banks, insurance companies and trusts). Foreign central banks are also important buyers of US government bonds. Countries like China and India run a huge trade surplus with the US, and the dollars they have accumulated through such trade are invested back in US securities (see previous post). Then there is the Federal Reserve. And this is where things get a little murky.

Federal Reserve, for all practical purposes, is simply an extension of the US Government. So, the Fed buying US government bonds is simply a transfer of debt from one part of the government to another. As for where does the Fed get the dollars to buy the bonds? It prints them. The Federal Reserve does not have the power of taxation to raise money, so it simply prints money to finance government debt.  This is referred to as monetization of debt or deficit financing.

The way this works is as follows. Suppose the US Treasury wants to spend USD 10 bn, but it only has USD 9 bn as tax revenues. It issues bonds for USD 1 bn in the market. The Fed comes in now to conduct its open market operations. It prints USD 1 bn and buys the bonds. Assume the interest payment on the bonds amounts to USD 10 mn. The Treasury pays this interest to the holder of the bonds, which is now the Federal Reserve. The Fed uses part of this money, say USD 1 mn, to pay for its day to day running expenses (like staff salary, premises, printing cost, etc) and holds USD 9 mn as surplus, which is returned back to the Treasury. And this completes the cycle.

So, when debt monetization takes places, what is the cost to the Treasury of financing the USD 1 bn deficit? It is simply the cost of printing that amount of money, i.e., USD 1 mn, which is 0.1 per cent of the deficit. This power to print money, and finance any deficit simply out of thin air, is referred to as ‘Seigniorage’ and is a sovereign prerogative of the government.

This is how Wiki defines the term ‘Seigniorage’,

“Seigniorage can be seen as a form of tax levied on the holders of a currency…. The expansion of the money supply causes inflation in the long run. This means that the real wealth of people who hold cash or deposits decreases and the wealth of the issuer of the money increases. This is a redistribution of wealth from the people to the issuers of newly-created money (the central bank) very similar to a tax.”

The above definition does a wonderful job of explaining the economic impact of seigniorage.  And the term assumes special significance in today’s economic scenario as going forward, the US governments is slyly going to rely on this form of taxation to get their fiscal house in order. In fact, given the scale of fiscal stimulus undertaken, it is in fact impossible to cover up for all that spending without significantly relying on seigniorage at some point of time.

The brunt of this will be borne by the people who hold dollars – the US citizen and foreign central banks who have dollar holdings. How all this will unwind in the future, will be very interesting to see. More on this in a subsequent post.

The world of finance…

16 May

I believe the world of finance is unnecessarily made out to be too complex. The greatest hurdle in promoting the finance literacy and increasing financial inclusion is the image of finance as an arcane world that is comprehended only by ‘experts’. And matters become worse when these ‘experts’ let you down, as was the case during the sub prime crisis. There is obviously a vested interest in keeping things the way they are. I really sometimes wonder that the art of investing if broken down to the bare basics, isn’t all that complex at all. The habit of saving and evaluating financial instruments like bonds, equities, commodities, etc for making an investment decision can be achieved without complete reliance on the people of finance.

The case which I find most disturbing is the way ULIPs are sold in India. Every instance that I have come across of ULIPs being peddled is fraught with so much of misinformation that it seems downright illegal. Having talked to numerous people who have bought this instrument for tax savings purposes, not even one has come out as having properly understood the pros and cons of buying a ULIP. Let me clarify one thing at the outset, ULIPs are not an inferior investment product. However, without understanding the basic structure of a ULIP and without comparing it with an ELSS scheme, an investor will not be in a position to understand that an ELSS may actually make more sense for him than a ULIP.

More on this later.

Liquidity Trap: Revisited

28 Apr

I had touched on the concept of liquidity trap in my previous few posts. I am revisiting the concept here in this small post for the benefit of those who might not still be clear about it. Look at the graph below.


It basically plots the benchmark interest rate set by the major cental bankers against time. What do you see? The benchmark interest rates for US has hit the zero lower bound while for UK and EU, they are very close to zero. Obviously, interest rates cannot turn negative. Now look at the graph below-


The inflation rate in the US has turned negative at -0.38 per cent for the month of March 2009 after a continued and sharp fall since July 2008. Let us compute the real interest rate in March 2009 for the US, which is defined as nominal interest rate minus inflation-

Real Interest Rate = 0.00 – (-0.38) = 0.38 per cent

Definitely low by any standards. However, consider what the real interest rate would have been if the inflation was something like 3.85 per cent (the average inflation rate in the US for the year 2008),

Real Interest Rate = o.oo – 3.85 = -3.85 per cent

Yes, a negative real rate of interest, which would have offered a much larger boost to the economy and given greater traction to the monetray policy operations of the Federal Reserve. As the economy heads deeper into deflation, even with the benchmark interest rates kept at zero, the real rate of interest, reflecting the acutal cost of borrowing, will keep on rising. The above situation is referred to as a liquidity trap and it is easy to see that the monetray policy becomes completely ineffective in influencing the economy, with fiscal policy being the only tool in the hand of the government to bring the economy out of a recession.

Published by: Ravi Saraogi

Sitting on Debt Dynamite

25 Mar

Glancing through Mankiw’s blog, I came across a startling fact- the US govt is expected to cumulatively borrow $9.3 trillion over the next decade. To put that into perspective, India’s GDP stands at about a trillion USD. Roughly thus, the US govt will borrow an amount equal to one India GDP every year.

US Fiscal Deficit

US Fiscal Deficit

The Congressional Budget Office, an independent body which has a mandate to provide the congress with “objective, nonpartisan, and timely analyses to aid in economic and budgetary decisions on the wide array of programs covered by the federal budget”, also estimates that the national debt to GDP ratio in the US would exceed 82 per cent by 2019, which is double the last year’s level.

National Debt to GDP

National Debt to GDP

The US fiscal deficit is expected to be $1.85 trillion in the present fiscal. The US GDP approximately stands at $14 trillion. That would put the current fiscal deficit at about 13 per cent of the GDP.  The only time the US government ran a deficit as large as this was before World War II.

The situation is startling indeed. And has resulted in some very uncomfortable questions doing the rounds. The venerable US govt treasury bills, branded the ‘safest asset in the world’, suddenly does not seem so safe now. The possibility of the US govt defaulting on its debt  is now at least being considered if not expected.

The foreign holding of US treasuries has throw in another aspect. Look at the pie chart below-

Foreign Ownership of US Treasuries

Foreign Ownership of US Treasuries

Around 28 per cent of the outstanding US treasuries is owned by “Foreign and International” entities – read this as the central banks of countries like Japan, China and India. And the spiraling US debt has made at least one creditor nation wary of the “safe investment” branding.  China, which recently surpassed Japan as US’s largest creditor (China holds $696 billion in U.S. treasury debt, more than Japan’s holdings of $578 billion. Foreign holdings of U.S. Treasury debt in the previous year stood at $3.1 trillion), expressed concerns regarding the ability of the US government in meeting it’s debt obligations. Wen Jiabo, the Chinese premier, recently said that China is “worried” about its holdings of  US treasuries and wants assurances from the US that the investment is safe. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets,” Wen said at a press briefing in Beijing.

I am still finding it difficult to digest the above. Nobody questions the safety of US treasuries. Or so I believed. The situation has come to this pass that a developing nation, one-fifth the size of the US economy, is counseling the US administration to honor it’s debt obligations!! The future holds very important questions in light of the above. Is the appetite for US treasuries falling? If yes, what implications does this hold for the US government in raising finance to get it’s economy out of recession? What are the implications for the value of the dollar-the world currency? And lastly, which asset will now take the place as the “safest asset in the world”? Questions worth pondering on…

Published by Ravi Saraogi

Liquidity Trap

21 Dec


From theoretical curiosity to a practical reality, liquidity trap has come to haunt the world’s largest economy with questions being raised as to whether US will also experience a “lost decade”, much like the Japanese, before things turn normal again. So while the specter of the liquidity trap is raging high, let’s try and understand what this phenomenon is all about.

With the Fed lowering the benchmark federal funds rate to nearly zero, you must have increasingly come across the term ‘liquidity trap’, describing the present economic condition in the US. In this article, we set the record straight and explain in lucid terms what liquidity trap is all about. If you really want to hear from the horse’s mouth what a liquidity trap is, then you should talk to John, (that would be John Maynard Keynes). Keynes had introduced the concept of liquidity trap in his description of the conditions prevailing in the US in the 1930s (the era of the Great Depression). Since a high tea with Keynes would not be possible, you could probably talk to some Japanese central bankers. After all, the Japanese economy has been diagnosed with a liquidity trap condition since the mid 1990s.

Japan has been a depressing yet fascinating story. Since 1990, the Japanese economy has been characterized by a secular recession. Economists of different clan, ranging from classical to Keynesians to neo classical, have studied the Japanese economy and have prescribed remedial measures, but to no avail. Lars E.O. Svensson (2003) in his paper Escaping From A Liquidity Trap And Deflation: The Foolproof Way And Others writes,

Expansive fiscal policy, with a big fiscal deficit, has not ended stagnation in Japan but has lead to huge national debt, close to 150 percent of GDP at the end of 2001 and still increasing. With regard to monetary policy, Bank of Japan lowered the interest rate to zero and kept it there from February 1999 to August 2000, and again from March 2001 until now. From March 2001, after long indecisiveness, it also attempted a so-called “quantitative easing,” a substantial expansion of the monetary base. During two years up to the spring of 2003, the monetary base was increased by about 50 percent. But these steps were not sufficient to induce a recovery.

So, what exactly is a liquidity trap? In a nutshell, liquidity trap refers to a condition when the monetary policy (policies which affect the money supply in an economy) becomes completely ineffective. Let us picture an economy suffering from stagnation in its GDP growth with deflating prices. To stimulate the economy, the central bank lowers the nominal interest rates in the economy. Lower interest rates will lead to cheaper credit, which will boost aggregate demand via increased investment demand and consumer spending. Let’s say the nominal interest rate was initially at 4 per cent which is then gradually reduced. The severe recessionary tendencies prompt the central bank in reducing the nominal interest rates all the way to zero per cent. A further reduction in the interest rates would imply a negative nominal interest rate, which violates the assumption of time preference of money, and hence is not a practical possibility. (Simply put, the nominal interest rate cannot be negative as that would mean that if you borrow Rs.100, at maturity, you would have to return back less than Rs.100, so, no sane lender will lend when interest rates are negative.) Thus, zero acts as a zero lower bound (ZLB) constraint for nominal interest rates.

If you would notice, we have used the word “nominal” to describe the interest rates. Though the nominal interest rates cannot be negative, the real rate of interest can be negative. Real interest rate is defined as,

Real Interest Rate = Nominal Interest Rate – Inflation

So if the nominal interest rate is say 5 per cent and the inflation rate is around 7 per cent, then the real interest rate will be -2. It should be noted that consumption and investment decisions are a function of the real interest rates and not nominal interest rates.

With the above base, let’s delve deeper into the world of liquidity trap. A liquidity trap situation is characterized when the nominal interest rate hits the zero lower bound constraint, and yet the real interest rate remains high. This happens when the economy is suffering from deflation which is not expected to change in the near term. Even if the nominal interest rate is held at zero, in case the price level in the economy is falling at the rate of 2 per cent, the real interest rate works out to be,

Real Interest Rate = 0 – (-2) = 2 per cent

So the catch is that it may appear that the interest rate in the economy is very low, but because of deflationary expectations in the economy, the perceived real interest rate is still high, and thus even a zero nominal interest rate may fail to stimulate aggregate demand in the economy via increased investments and consumer spending. This is why in a liquidity trap, monetary policy becomes ineffective and even a zero interest rate policy (ZIRP) is ineffective in gaining traction on the economy.

It would be interesting to note that in a liquidity trap, with very low nominal interest rates, open market operations, perhaps the most important tool for conducting monetary policy, itself breaks down. Open market operation refers to the buying and selling of government bonds by the central bank of a country. When the central bank buys government bonds in the market, it increases the money supply in the economy (as money is put into the hands of the people previously holding the bonds), and when it sells government bonds, it reduces the money supply (as people previously holding money exchange it for bonds). Now, when interest rates are zero, people would prefer to hold money (which has the added advantage of liquidity) over bonds. Thus open market operations emerge as a very important tool for changing the money supply and hence conducting monetary policy. In a liquidity trap however, the demand for money becomes infinite, i.e. money demand becomes perfectly elastic, and hence come what may, people will only prefer to hold money and not bonds. Thus the policy of trading in bonds to influence money supply breaks down.

(The discerning might question the above logic saying that even if the nominal interest rates are zero, there might still be some demand for bonds because real interest rate is strictly positive. A valid point. However, even if the real interest rates are positive, investing in bonds in a liquidity trap will entail a capital loss as going forward, because of the zero lower bound constraint, the only movement future nominal interest rates will show is up, and given the inverse relationship between bond prices and interest rates, bond prices will fall in future.)

A liquidity trap is potentially dangerous as it leads to a breakdown in the transmission mechanism. Generally, a lower signaling interest rate set by the central bank lowers the overall level of interest rate in the economy. Banks lend more on the back of increased demand for credit, both for investment purposes and for consumer spending (like home loans, car loans, etc), which leads to increased aggregate demand. This is how monetary policy works. In a liquidity trap however, the story is different. Recall that a liquidity trap occurs in a situation of recession in GDP growth and deflation, when interest rates are lowered to fight the slowdown. The depressing economic scenario in which a liquidity trap occurs is also accompanied by negative business and consumer sentiments. At such times, which is generally a fall out of some economic crisis, even if liquidity is made available, economic agents may be too risk averse to use the liquidity and may simply sit on such liquidity (i.e. hoard money). Banks may refuse to lend, either on account of increased risk aversion or on account of reduced incentive to lend as interest rates are near zero. Even if credit is supplied, with prices showing a downturn, entrepreneurs will refuse to invest in production. Even if the government increases the money supply through deficit financing (printing of money), people just sit on reserves of money and hoard it. This led Milton Friedman to suggest that a way out of a liquidity trap would be to stash money in the hands of the people and ask them to spend it. Such an approach is called ‘helicopter money’ as it brings up images of the central banker flying in the air and dropping bundles of cash at the people (see image below).


Central bankers are petrified of a liquidity trap as shooing it away requires managing expectations in an economy. If we recall the root cause of a liquidity trap, it is high real interest rates in the face of zero nominal interest rates. Lowering the real interest rate in the economy when the nominal interest rate has already hit the zero lower bound would require stoking up inflationary expectations in the economy. It is only when sufficient inflationary expectations in the economy have been generated that the perceived real interest rate will come down and the transmission mechanism will work. This is not an easy task for a central bank which has throughout its history sought to build a strong reputation for fighting inflation in order to enhance its credibility, and certainly not an easy task for ‘inflation hawks’ like the Japanese Central Bank and the Federal Reserve.

Economists have come up with different suggestions for stoking inflationary expectations in the economy, like following a price target path, commitment to inflation, increasing money supply further, currency depreciation, aggressive fiscal policy through government borrowing, etc.

However, as the Japanese case would suggest, shaping expectations in an economy is not an easy task as it would depend on the credibility of any announcement coming from the central bank. If people believe that as soon as inflation rears it ugly head and the recession tendencies wane, the accommodating monetary policy will be reversed by the central bank, then the remedial measures to escape from a liquidity trap will be ineffective. Only when the central bank declares that monetary easing will persist in the near future, even if inflation turns positive, and people believe in the declaration, will the policy be effective in defeating a liquidity trap. Declaring is easy. Making people believe is the difficult part.

In the Japanese case, the loose monetary policy directed towards generating inflationary expectations was ineffective as the exchange rate was not allowed to depreciate simultaneously (an inflationary policy should manifest itself in an exchange rate depreciation as it lowers the value of the domestic currency). A depreciating yen along with monetary easing would have given much more credibility to the policy for stoking inflationary expectations in the Japanese economy. However, the lack of depreciation in the domestic exchange rate gave away the fact that the Japanese central bank was still apprehensive of giving inflation a free hand in the economy over a medium term.

According to Paul Krugman, a central bank caught in the vortex of a liquidity trap has to have an explicit mandate to behave ‘irresponsibly’ by generating inflation in the economy. And it should take all steps necessary to prove the point that it is irresponsible. Guess it’s time to add a new chapter on the functions of a central bank…

Published by Ravi Saraogi