Capitalism & Socialism - Lecture Series - Part V - Notes

Today's post is about the infamous liquidity-trap. When I gave the lecture, this part was very well discussed with lots of interesting questions around this subject. If you are a fan of Prof. Krugman, you dont have to necessarily continue reading this post, as he has been too vocal about this for the past many months. 

But before stepping into the trap, let us look at one important factor - savings. Generally savings is a virtue and people are encouraged to save more. If there were no government intervention in the world (a free market capitalist dream), then this is what would happen - consumers will save more, which means they will spend less. This will automatically result in lower production of goods which reduces efficiency as well as workforce numbers and profits for companies. As a result, salaries will get lower for consumers and in turn, because of this, consumers will start saving even more. This will only detoriorate the situation further, giving rise to a vicious circle. 

However in reality, there are governments. And when there is lot of savings trying to pull down the economy, governments lower interest rates thereby boosting investments. These investments ensure that there is sufficient liquidity in the markets. Thus even though consumers save, the situation is not all that bad, as government tries to balance the act from supporting the investment angle.

Now let us come to the crux of the topic. What if consumers are continuing to save, there is little liquidity in the market and the interest rates are too low that they cannot be cut any more (or cutting them down wouldn't make much of a difference)? Such a situation is called the liquidity-trap. This is what Japan has found itself in; this is what the US is probably heading towards. The interest rates in Japan are already hovering around 1%. The US interest rates are also similarly at 1%. Even if Ben Bernanke of the Fed decides to cut the interest rates, how much can he? If he makes it to 0%, will that be sufficient to boost the economy?

This is a trap as we can see, which gives no clear traditional routes to help the economy bounce back. In such situations, bailout packages become clearly necessary and that is when socialization of losses occurs. (The free market capitalists do believe in these kinds of socialistic principles as it suits them!). Remember that we are not talking about a third world impoverished country here. We are talking about America, the world's superpower. And this is a nation that will not hesitate to initiate a World War III if it only means that it will boost their economy.

The advocates of free market capitalism fail to address clearly such complex situations. While in theory, everything is a resource and can be scaled up and down as the situation demands, it is just theory. In reality, such corrections do not occur so easy and so fast. An example is wages. While wage increase is a demanded norm (in any market), wage decreases to support the economy are not and they tend to be sticky. And I think this may be a good time to start thinking about what Keynes said.