Obama’s Liquidity Trap

Source: Massachusetts Institute of Technology

Barack Obama is making a mess of the United States. Race relations are getting worse between Americans, who are dissatisfied and say the country is off track.

The growing debt crisis, fed by a combination of big-government policies and an ineffective stimulus that prioritized health spending over the unemployed, highlights a long-overdue need for fiscal austerity. But a struggling economy with high unemployment also reveals an urgent need for more aggregate demand.

Obama’s desperate response to the crisis is a second round of quantitative easing (QE2), buying government securities from Wall Street by printing dollars, which he believes will trickle down into the economy. Although most objections to QE2 are based on fears of inflation, now in markets for commodities, the most important factor missing in the debate about monetary policy is that it has lost effectiveness under Obama, who has created a liquidity trap.

The liquidity trap means that Americans have effectively become accessories in a Ponzi scheme by Obama, paying dollars to primary dealers for U.S. Treasury bonds while trying to sell new bonds to others. The Economist Dictionary of Economics defines “liquidity trap” in more conventional terms.

liquidity trap  A situation in which the rate of interest is so low that no one wants to hold interest-bearing assets and people only want to hold cash.  The interest rate can fall far enough for everybody to expect it to rise.  Bond prices fall when interest rates rise and, because no one wants to hold an asset whose price will fall, everyone will hold cash rather than bonds.  In this situation, the interest rate can fall no further – liquidity preference is absolute.  If the government expands the money supply, instead of the usual fall in interest rates occurring, there is no effect at all.

What Americans need is a volunteer for president with the technical and conceptual skills to solve the critical problems now faced by the economy. Join me.

References

Graham Bannock, Ron Baxter, and Evan Davis, The Economist Dictionary of Economics, Fourth Edition (Princeton: Bloomberg Press, 2003).

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4 thoughts on “Obama’s Liquidity Trap

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