Guest Post: Larry Summers Admits The Fed Is In A Liquidity Trap

I recently wrote an article entitled "What Is A Liquidity Trap & Why Is Bernanke Caught In It?" wherein I discussed the definition of a liquidity trap as:

"A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in the general price levels."

Importantly, this evidence is mounting that the Federal Reserve has now become trapped within this dynamic.  The boost in asset prices caused by the increased levels of liquidity in the system has benefited the wealthy while doing little to jumpstart the real economy.  As I stated previously:

"However, the real question is whether, or not, all of this excess liquidity and artificially low interest rates is spurring economic activity?  To answer that question let's take a look at a 4-panel chart of the most common measures of economic activity – Real GDP, Industrial Production, Employment and Real Consumption."

"While an argument could be made that the early initial rounds of QE contributed to a bounce in economic activity; it is also important to remember several things about that particular period.  First, if you refer to the long term chart of GDP above you will see that economic growth has ALWAYS surged post recessionary weakness.  This is due to the pent-up demand that was built up during the recession that is unleashed back into the economy.   Secondly, during 2009 there were multiple bailouts going on from 'cash for houses', 'cash for clunkers', direct bailouts of the banking system and the economy, etc.  However, the real test for the success of the Fed's interventions actually began in 2010 as the Fed became 'the only game in town'.   As shown above, at best, we can assume that the increases in liquidity have been responsible in keeping the economy from slipping into a secondary recession.  Currently, with most economic indicators showing signs of weakness, it is clear that the Federal Reserve is currently experiencing a diminishing rate of return from their monetary policies."

From this standpoint it was shocking to see someone, particularly Larry Summers, actually discuss this issue during a recent CNBC interview stating his case on why it is wrong to rely on monetary policy as the main driver of the economy.

The important point is that, for the first time that I am aware of, someone has verbally stated that we are indeed caught within a liquidity trap.  This has been a point that has been vigorously opposed by supporters of the Federal Reserve actions.

Of course, the lack of transmission of the current monetary interventions into the real economy has remained a conundrum for the Federal Reserve as the gap between improving economic statistics and the real underlying economic fabric continues to widen.  As Larry states, we are indeed in uncharted territory.  With the direct manipulation of interest rates near impossible, it leaves only verbal (forward guidance) and liquidity (increases of excess reserves) policy tools available.  The problem is that these tools have never been used to such a massive extent before in history.  While analysts and economist continue to suggest, with each passing year, that stronger economic growth is coming; it has yet to be the case.  As discussed previously, this is a tell-tale sign of a liquidity trap.

My belief all along has been and remains that a well thought out combination of both fiscal and monetary policy is the correct remedy for what ails the U.S. economy currently.  However, up to this point, the Fed has been the "only game in town" to quote the famous words of Senator Chuck Schumer.   I have to admit that I was pleasantly surprised by Larry Summers view point as I believe that it is the correct one at this late stage of the current economic recovery cycle.