Liquidity Trap: Treasury and Mortgage Rates Rise While Money Velocity Plummets

I was just interviewed by WMAL radio in Washington DC on real estate and mortgage rates. Of course, I was asked what is happening to mortgage rates. I mentioned that the US economy is in a liquidity trap (where injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth).

In fact, interest rates have been rising over the past several months. Since last November, the 10 year Treasury yield has risen.

The Ginnie Mae current coupon (the pass through rate to MBS investors) has risen with mortgage rates.

The DB MBS Ginnie Mae 30Y Index (Option Adjusted Duration) continues to climb since October.

Here is the problem with the residential mortgage market. Mortgage purchase applications have been stuck in a rut since 2010.

The M1 Money Multiplier continues to decline indicating that for every dollar created by the FED (an increase in the monetary base M0) will result in a <1 dollar increase of the money supply (M1).

And M2 Money Velocity is abysmal. Velocity is a ratio of nominal GDP to a measure of the money supply. It can be thought of as the rate of turnover in the money supply — that is, the number of times one dollar is used to purchase final goods and services included in GDP.

So, until the M1 Multiplier and M2 Velocity get back to normal ranges, we are more likely to be shot at by a flying drone than to see a vibrant economic recovery.

The Liquidity “Trap”

The ultimate weapon in the Keynesian arsenal of explanations of depressions is the “liquidity trap.” This is not precisely a critique of the Mises theory, but it is the last line of Keynesian defense of their own inflationary “cures” for depression. Keynesians claim that “liquidity preference” (demand for money) may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression. This statement assumes that the rate of interest is determined by “liquidity preference” instead of by time preference; and it also assumes again that the link between savings and investment is very tenuous indeed, only tentatively exerting itself through the rate of interest. But, on the contrary, it is not a question of saving and investment each being acted upon by the rate of interest; in fact, saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with this matter. Keynesians maintain that if the “speculative” demand for cash rises in a depression, this will raise the rate of interest. But this is not at all necessary. Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption-investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on “liquidity preference.” In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall—because time preferences have fallen.

In their stress on the liquidity trap as a potent factor in aggravating depression and perpetuating unemployment, the Keynesians make much fuss over the alleged fact that people, in a financial crisis, expect a rise in the rate of interest, and will therefore hoard money instead of purchasing bonds and contributing toward lower rates. It is this “speculative hoard” that constitutes the “liquidity trap,” and is supposed to indicate the relation between liquidity preference and the interest rate. But the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate—the “profit spread” on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate. What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers’ goods prices falling faster than do consumer goods’ prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned “classical” speculation on price changes. This expectation, far from being an upsetting element, actually speeds up the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from “speculative” hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.[3]

Such intelligent neo-Keynesians as Modigliani concede that only an “infinite” liquidity preference (an unlimited demand for money) will block return to full-employment equilibrium in a free market.[4] But, as we have seen, heavy speculative demand for money speeds the adjustment process. Moreover, the demand for money could never be infinite because people must always continue consuming, on some level, regardless of their expectations. Since people must continue consuming, they must also continue producing, so that there can be adjustment and full employment regardless of the degree of hoarding. The failure to juxtapose hoarding and consuming again stems from the Keynesian neglect of more than two margins at once and their erroneous belief that hoarding only reduces investment, not consumption.

In a brilliant article on Keynesianism and price-wage flexibility, Professor Hutt points out that:

No condition which even distinctly resembles infinite elasticity of demand for money assets has even been recognized, I believe, because general expectations have always envisaged either (a) the attainment in the not too distant future of some definite scale of prices, or (b) so gradual a decline of prices that no cumulative postponement of expenditure has seemed profitable.
But even if such an unlikely demand arose:

If one can seriously imagine [this situation] . . . with the aggregate real value of money assets being inflated, and prices being driven down catastrophically, then one may equally legitimately (and equally extravagantly) imagine continuous price coordination accompanying the emergence of such a position. We can conceive, that is, of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way.[5]
...

from:
America’s Great Depression
By Murray N. Rothbard

Keynesian Criticisms of the Theory[1]

http://mises.org/rothbard/agd/chapter2.asp

Me? Keynesians confuse money with wealth. Moreover, when a substantial amount of wealth in an economy is tied up in perpetual debt that is “serviced” merely by rolling the note over with new debt, then substantial forces exist that cause grotesque distortions in the monetary system in a vain effort to hold the value of the currency unit constant, which it CAN NEVER BE! (The value of money must be allowed to fluxuate just like any other commodity)

In a fully free economy, there cannot be a “liquidity trap” simply because what counts is the relative value of assets, wages and prices. Falling prices for everything result in falling wages. What counts is the number of hours worked required to buy food, clothing and shelter. The spoiler here will be long term debt because both lender and borrower have locked themselves into a nominal value contract no matter what the real world does to the value of money in the future.

We can have falling wages and prices and still be more individually prosperous. The biggest debtor is government and it is desperate to maintain the fiat currency system. In a hard-asset system like gold, nobody would care, that is except the long term lender who wants to be repaid in like value.

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