A liquidity trap?

Are we in a Keynesian-style liquidity trap? That's one question raised by the small reponse of money market rates to Wednesday's promise by central banks to pump more cash into the markets.
The idea here is straightforward. As Keynes said, it is possible that:

Liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

This might describe what's happening now. Banks' desire to cling onto cash is so absolute that promises to increase the money stock have little impact upon interest rates; as Willem Buiter says, uncertainty about counter-party risk is paralyzing lending and making banks sit on cash. Monetary authorities have therefore lost control of the interest rate. Or at least stock markets fear that they have - hence their poor response to central banks' announcement.
Which is weird, because we normally think of liquidity traps happening (if they do so at all) when interest rates are low rather than around normal levels as they are now.
So, what's the solution? One possibility is just to wait.  Once banks have worked out exactly what their losses on sub-prime debt is, their precautionary demand for cash might dwindle, sending Libor down.
But there's another possibility. Maybe rates haven't responded much to central banks' promise because banks fear that the cash injection will be withdrawn once conditions look like stabilizing. If this is the case, central banks might have to heed Krugman's advice, to commit to being irresponsible, to continue to pumping money into markets after it's necessary.   
This means they face a nasty trade-off. On the one hand, restoring money markets to health requires that they raise banks' profit expectations, by offering lots of cheap money. But on the other hand, this raises not just the threat of inflation, but serious moral hazard problems.

Comments

[Luis Enrique]

Are banks holding on to their cash because they do not know their own positions, and worry they may need it themselves, or are banks holding on to their cash because they don't want to lend it to another bank whose collateral may turn out to be a turd parcel? Or both?

What sort of mechanism is going to reveal to banks the true nature of their own position (if that's the problem) or who is holding the turd parcels (if that's the problem)?

I'm thinking perhaps the offer of cheap money secured against a broader class of assets may ease both problems, because it doesn't matter so much to banks either what their own positions are, or that of those they lend to (if a bail-out is on hand in any eventuality).

But what if the availability of cheap money somehow just defers whatever the mechanisms are that's going to reveal the missing information? Does anybody know enough about banking to explain, if this line of reasoning is correct, what those mechanisms are? Is the announcement of write-downs enough?

[dearieme]

"..when interest rates are low": maybe REAL interest rates are low, in the sense of nominal rates minus expected inflation rates.

[Marcin Tustin]

Hmm, if the carrot doesn't work, what about the stick?

Perhaps dearieme is right and the quantitative easing is driving down real interest rates. Similarly attempts to target growth by the Bank of England.

Perhaps a better response would be comprehensive deposit insurance, then have the central banks return to strict inflation targeting, combined with technical changes on allowable collateral (known mortgages with a loan-to-value of less than 1 as well as gilts and other sovereign debt.)

[Trooper Thompson]

I suggest we need to face up to the pyramid scheme logic of our current (world) financial system. As money is based on debt, we are grabbing onto an ever-rising balloon. How about getting rid of fractional reserve banking, and making the Government issue the currency, not a private banking monopoly?

[tolkein]

Perhaps we'll find out if auditors can find out bad stuff and force the banks to value their less liquid 'assets" more realistically. In other words, now is the time for serious write downs, and then for confessions about how all this talk of better ways of pricing and sharing risk turned out to this years b*ll*x.

[Shalom Hamou]

We are not in a liquidity trap yet: central banks can still pump cheaper money but there is a limit to that exercise.

Today in order to be neutral short term rates should be 2% rather than their actual rates.

The present crisis is precisely the result of an experiment by the FED of trying to generate growth of long term rates through increase of short term rate.

As long term rates follow they downtrend since 1981 we will reach the dreaded liquidity trap.

What we must understand is that emitting money through credit is inefficient and dangerous.

What we need is an adjusted credit free free market economy.

It is more easily said than done.

But we have no other choice

Shalom

[Air Jordans]

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