US falls into liquidity trap

Business | Andrew Wong 22 Jul 2019

While US stocks continue to hit new highs, investors seem to be unaware that America may have followed Japan into a liquidity trap.

The liquidity trap is a theory put forward by British economist John Maynard Keynes. In Keynesian economics, a liquidity trap happens when monetary policy fails to stimulate the economy, and there is no way for either lower interest rates or increased money supply to work.

A liquidity trap typically appears when the economic outlook is not clear, due to deflation, insufficient aggregate demand, war, etc. Because the outlook is not clear, holders of liquid assets are not willing to invest and the monetary policy brought by the stimulus is greatly reduced.

Most people may think that the trade war started by the United States is a major reason for a liquidity trap.

However, I have said before, the most likely reason why US President Donald Trump embarked on a trade war was because the Fed's tightening had made the US economy lose steam while his tax cuts failed to deliver the promised growth.

Thus, Trump launched a trade war to reduce America's trade deficit and power up the US economy.

This means that America's economy had been slowing down before the trade war, and as the tax cuts failed to produce the desired results, the United States has fallen into a liquidity trap to some degree.

We can also analyze possible liquidity trap problems in the United States with scientific data. Among them, velocity of money is a key way to determine this because one of the characteristics of a liquidity trap is that short-term interest rates are close to zero, while velocity of money is unable to affect the growth rate of prices.

America's M2 velocity of money has been on a downward trend. It fell to a record low level of 1.433 in 2017 and has continued to languish since then.

More importantly, the fall in M2 velocity of money actually began in 1998, when the data was at the 2.2 level, which explains why the US Federal Reserve in September 2007 began to cut interest rates, even as the launch of quantitative easing failed to stimulate the rate of inflation in the United States.

In fact, after the American economy structure turned into the consumption mode of credit leverage, the Federal funds rate had begun to peak 40 years ago, and after each economic cycle, the rate fell lower and lower.

At the same time, before the Federal began to tighten monetary policy, the economy started slowing down, eventually forcing the Fed to cut interest rates again.

After the 2008 financial tsunami - when interest rates had fallen to historic lows and to nearly zero levels - the Fed was forced to launch QE.

However, it seems that the momentum brought by QE to the economy has been very limited.

After the launch of QE, there was a V-shaped rebound, but it was not sustained after that. This seems to show that the United States has already fallen into a liquidity trap. Next week, let's delve deeper into why this happened.

Andrew Wong is chairman and CEO of Anli Securities

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