The Liquidity Trap of the 1930s and Its Relevance Today

I am no expert on the Great Depression, but I have read about it and I agree with the author of the article from Market Watch that things are setting up like the 1930s (see previous post). In addition it is hard to tell what will happen because this is a dynamic (as opposed to linear) process, but it is time to start being aware of the history of Great Depression. Text in bold is my emphasis.

We learned this in the 1930s, when, after first shrinking the money supply enough to pull prices down by about 25%, the Federal Reserve of that era tried to force-feed liquidity into the economy with the hopes of pushing it out of its slump.

It didn't work. Lenders were reluctant to lend, while potential borrowers did not want to borrow.

Banks were struggling under mountains of loans gone sour and were in no frame of mind to throw good money after bad. For their part, most firms were not willing to assume new debts, since falling sales and earnings led them to conclude that there was little productive use they could make out of these borrowed funds.

The great economist John Maynard Keynes dubbed this phenomenon a "liquidity trap." It was perhaps the first realization that the Fed's powers were not as great as previously thought. (If you think about it, this is the same thing that is keeping Japan down for the last 15 years.)

This was most disconcerting, since the main reason behind the creation of the Fed back in 1913 was to ensure that panics, such as the one in 1907 that was caused by insufficient liquidity in the economy, could be nipped in the bud - if not prevented altogether by a generous dollop of liquidity from the central bank.

The Panic of 1907, like others before it, led to a recession. The liquidity trap of the 1930s was part and parcel of what came to be known as the Great Depression.

Today there are some similarities to the liquidity trap of the 1930s. The credit crunch is clearly one of them. No matter what the Fed does on Tuesday, it will not be able to thaw out the frosty financial markets.

This is because the markets lack confidence. As I wrote two weeks ago, "fear, and not a lack of liquidity, is what's freezing up the credit markets ... and ... it's going to take a lot more than infusions of liquidity to thaw them."

You know that fear is stronger than greed these days when banks refuse to lend to each other - never mind to businesses or to consumers.

A good indication of this is the three-month LIBOR spread against comparable maturity Treasuries. It's over 200 basis points (2 percentage points) today versus an average of about 25 bps between 2003 and this past spring.

What's driving this fear is uncertainty over the underlying value of securities backed by home mortgages.

Treasury Secretary Henry Paulson's offer to freeze interest rates for as long as five years for some subprime borrowers raises more questions than it answers - not the least of which is setting a precedent of government intervention changing the rules of the game for investors.

The value of these mortgage-backed securities will also be determined by what happens to housing prices, and as I wrote last week, nationally, median home prices will have to fall at least another 20% before families can afford to buy.

There's little the Fed can do at this point other than injecting liquidity to push rates lower while persuading lenders to make credit more readily available.

However at some point the Fed will have to draw the line, lest it create not only a new moral hazard, but the groundwork for a new round of inflation as well.