Keynes and the liquidity preference

Will the Fed make another half point interest rate cut? If so, will finance react at all? Howard M Wachtel, an Economics professor at American University points to an important lesson from JM Keynes on the futility of monetary policy during a downturn:

Take one issue – interest rates. The U.S. Federal Reserve’s policy of lowering interest rates, from 5 and 1/4% in August 2007 to 2% in May 2008, was a grave mistake that could have been avoided if Keynes’ analysis had been part of the Fed’s policy making knowledge. The Fed’s error in interest rate policy was compounded when it followed interest rate reductions that did not work with large infusions of new money into the financial system.

Keynes taught us that when banks and other holders of vast sums of capital have what he called a “preference for liquidity” – a desire to hold cash and not invest it – lowering interest rates will not unlock this liquidity for investment. Instead any infusions of new money by the central bank into the system will simply be stashed away for two reasons: first, the mood of the financial market’s psychology is glum and not conducive to investment because rates of return are perceived to be too low. Second, new money injected will be held as cash in anticipation of a better day, so the new money will be seen as an arsenal to be held until markets improve.

Added to this is the character of this most recent bubble – inflated home prices and their accompanying high-risk financial instruments to insure these bad loans. Lowering interest rates simply poured fuel on the fire by keeping loan rates low, encouraging more imprudent lending and borrowing, and furthering the speculative bubble’s chain of bad debts.

This reasoning is counter-intuitive, but it fits the current paradox of lower interest rates and unprecedented chunks of cash interventions without their anticipated impact. The preference to hoard money by banks reinforced a psychological condition that was confirmed by the failure of the lower interest rates to have their intended effect. Credit markets in today’s language have frozen.

Keynes called this the liquidity trap – the most difficult position for an economy, one that characterized the Japanese economy in the 1990s, and threatens to engulf not only the U.S. but the global economy today.