Academic journal article ABA Banking Journal

"Liquidity Trap"? What about the "Machiavellian Trap"?

Academic journal article ABA Banking Journal

"Liquidity Trap"? What about the "Machiavellian Trap"?

Article excerpt

MUCH HAS BEEN SAID ABOUT the inability of monetary policy to stimulate economic recovery. Economists call this situation a "liquidity trap," where low interest rates--now close to zero percent--have no effect on the important economic variables, like consumption or investment. This liquidity trap is one of central bankers' biggest fears, and together with deflation, one of the most difficult situations to be in, because there is no easy way out.

Nonetheless, monetary policy still has more ammunition, some having nothing to do with injecting more money into the U.S. economy. The Bernanke Federal Reserve has been extremely innovative, to say the least, in this regard. What monetary policymakers need to be doing is preventing speculation on pseudo-proposals to fix the economy. The Federal Reserve governors should actively speak out against ideas such as the recent suggestion for it to target mortgage interest rates at 4.5%.

There are at least two reasons to oppose this idea. First we must ask: will potential homebuyers proceed with their plans to lock in attractive 5.7% fixed, 30-year mortgages after hearing that the government is planning to offer 4.5%? Of course not! This speculation is plainly and simply delaying a recovery in the housing market.

A second problem with targeting mortgage rates at 4.5% is that below-market mortgage rates are at least partly to blame for the current collapse of home values. The financial services industry came up with mortgage instruments that, with the tacit support of the Federal Reserve and the government, pushed short-term mortgage rates so low that sectors of the population that were not capable of paying higher rates could buy into the American dream of home ownership. …

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