[FC, maybe you can answer this question for me. The Fed is pumping money into the system like crazy. Where is the money going? The banks don’t seem to be lending it. Are they sitting on it? Or, are they buying T-bills? Is the Fed shoveling it out one door and shoveling it in the back door? ]
I think it’s sitting in the banks, but they are all scared to lend, so they are sitting on the capital. We are in a huge credit contraction, thus deflation right now. But we still have a couple trillion about to be pump out there, so at some point the game of musical chairs begins.
As far as T-bills goes, other nations are snatching those up as fast as they can, though the return is so low it is essentially a loss after administrative costs. Yep, other nations see nothing better to invest in in their own countries, so are buying T-bills at a loss. That is what they see as the safest bet.
The multiplier right now is exactly 1, meaning that - just like everyone else - the banks aren’t lending or spending. Why would they? In a deflation the inherent 0% rate of return on cash is actually a pretty good risk/return tradeoff. And Japan has taken 15 years to prove that throwing money at a multiplier of 1 is a waste of time.
Here’s what some of the most prominent economists who have studied deflation, liquidity traps, the Great D and Japan’s lost decade say (Bernanke, Svenssen, Krugman, Anna Schwartz, the Romers, Feldstein), and it’s all pretty depressing:
The nature of a bubble-deflation or debt-deflation is a pattern of mutually reinforcing solvency crises, confidence crises, and output reductions. From one side of the MV=GDP=PY equation, the money multipler and velocity plummet due to the solvency and confidence crises, and from the other side output plummets as over-production is scaled back. Price movements and broad money measures are just a trailing reflection of the underlying problems.
Zero interest rate policy (ZIRP) is an ineffective stimulus, because it is paradoxically both too high and too low. First, any nominal interest rate that is not well into negative territory (right now, estimates range from -2.5% to -5%) is still to too high in deflation-adjusted terms to (theoretically) encourage lending, borrowing and investment. However, 0% is the exact nominal yield of mattress-money (or its banking equivalent, excess reserves) - therefore the risk/return tradeoff for lending is not favorable compared to the risk/return tradeoff of hoading cash. Additionally, due to low confidence, the perceived risk/return tradeoff for borrowing money for either consumption or investment is also unfavorable compared to just waiting until prices drop further or until investment conditions improve.
http://www.federalreserve.gov/pubs/feds/2004/200448/200448pap.pdf
http://web.mit.edu/krugman/www/bpea_jp.pdf
Quantitative easing (QE) may help temporarily dampen a solvency crisis, but it cannot simultaneously solve the three crises in solvency, output and confidence, and the result of Japan’s experiment has been to delay badly needed structural reforms. First, the mechanics of QE tend to artificially prop up the economically and financially weakest institutions, creating unproductive zombie institutions that are only solvent while on government assistance, with little incentive to reduce systemic risk. Additionally, the economy comes to realize that any reinflation of money is short-lived. In QE, the Fed monetizes Treasuries, agency bonds, MBSs, CDSs, and anything else it can buy, thus injecting money into the economy - in essence using its magical powers to convert those instruments into brand new “money.” It does so in the hope of stabilizing the solvency crisis, of reigniting the multipler and velocity, and sometimes even of bypassing them altogether and directly inflating broad money measures. The drawback is that it eventually becomes public knowledge that the Fed eventually must demonetize (that is, re-deflate its own QE re-inflation), and that any inflation is temporary noise in a longer-term trend.
http://www.federalreserve.gov/pubs/feds/2004/200448/200448pap.pdf
http://www.frbsf.org/publications/economics/letter/2006/el2006-28.pdf
Krugman’s proposal that the Fed “credibly promise to be irresponsible” and build a self-fulfilling expectation of inflation is also unconvincing. The essense of Krugman’s proposal is to create a perception that by ZIRP and QE the Fed will somehow dramatically overshoot its inflation target, thus encouraging people to part with their money, and ultimately restoring economically productive lending and spending. The underlying risk is that instead of restoring confidence in the economy or financial system, it further increases pessimism, igniting a flight to the perceived relative safety of foreign currency and gold. Krugman himself recently stated that such a measure requires creativity and luck, not the best foundations for monetary policy.
http://krugman.blogs.nytimes.com/2008/12/17/a-whiff-of-inflationary-grapeshot/
http://krugman.blogs.nytimes.com/2008/11/15/macro-policy-in-a-liquidity-trap-wonkish/
Svensson’s Foolproof Way to Escape From a Liquidity Trap focuses on devaluing the dollar against other currencies (in conjunction with ZIRP and QE to peg that depreciation). However, it has a surprisingly obvious draw-back in a global deflation. Specifically, that policy cannot be simultaneously successful at the five key global central banks - the Fed, Japan, Europe, London and China. In a simultaneous crisis in those five economies, there will either be big winners and big losers, or a combined overall failure (more likely due to growing monetary interdependence), or in the worst case a race to the bottom and eventual flight to gold. Japan and China have already demonstrated their unwillingness to let the West undermine either their export base or the value of their dollar investments. While Svensson prescribed such a measure for Japan in 2003 (when it was in a self-contained trap) or for Europe or the US if it ever found itself in a contained trap, he never explicitly described it as a solution for global deflationary contagion.
http://www.princeton.edu/svensson/papers/js.pdf
http://www.nber.org/papers/w10195
While fiscal policy may provide a fleeting cushion against rapid deterioration, it cannot trigger a recovery. Any combination of increased deficit spending - in lower taxes and/or higher spending - suffers from a prohibitively slow lag to full implementation, and from the effects of low velocity. Additionally, counter-cyclical fiscal policy by definition requires pre-deflation surpluses. The existing pre-deflation deficits further reduces the expectations of effectiveness that are needed to drive money through the economy. Modern infrastructure projects are the most ineffective of fiscal measures, because of the slow lag time to initiate, and because most require trained and ready workers... the days of handshovels are long gone.
http://www.econ.berkeley.edu/~cromer/RomerDraft307.pdf
http://www.econ.berkeley.edu/users/cromer/great_depression.pdf
http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2005-039.pdf