Gone4Good
Give me a museum and I'll fill it. (Picasso) Give me a forum ...
- Joined
- Sep 9, 2005
- Messages
- 5,381
A Detailed Example
Laziness has prevented me from walking through a full-blown example of what I’m talking about, so I suspect much of what I’ve been saying sounds like gobbledy-gook (queue snide remarks from the usual characters). But here goes, for those who have the patience for it:
At the macro level the world is a closed system. Inputs equal outputs. The simplest way to see this is that for every borrower, there is a lender. One person’s debt is another person’s asset. At the macro level, we don’t act in isolation. Your Yin is my Yang.
With that in mind, consider a world with only two people Brad and Sarah. This world has only two products, Widgets and Gazzoos. Brad produces Widgets, Sarah produces Gazzoos and they trade with each other. In this world, GDP equals the total amount of Widgets and Gazzoos produced. Brad uses his Widgets to trade for Gazzoos and vice versa. The more Widgets he produces, the wealthier he is. This is the basis of “Classical” economics, and the underlying rationale to focus on the economy’s “Supply side.”
Now add money and an interest paying bond for savings. Suppose Brad doesn’t want to use all of his income to buy Widgets and Gazzoos? In that case, he can make his extra income available to Sarah, who wants to consume more. Sarah borrows from Brad, and consumes the production Brad doesn’t want. The interest rate charged reflects the balance between how much consumption Brad is willing to forego, and how much extra consumption Sarah wants. Let’s say 5% is the equilibrium rate.
If Sarah decides she’s borrowed too much, she starts consuming less and repaying Brad’s loan. Brad isn’t interested in consuming more when he can lend at 5%, but Sarah wants to consume less if she’s got to borrow at 5%. So the interest rate declines. At 4% Sarah is still willing to borrow and consume, but less than she did before. At 4% Brad is still willing to lend and save, but less than he was before. Output of Widgets and Gazzoos remain unchanged.
Now let’s assume something dramatic scares Brad & Sarah (space aliens?) to the point where Sarah wants to repay her loan but Brad doesn’t want to decrease his savings. Sarah starts trying to repay her loan but Brad wants to keep lending, so interest rates decline further . . . from 4%, to 3%, 2%, 1% and finally down to 0%.
Even when Sarah can borrow at 0% she feels she already has too much debt and wants to pay Brad back. Those space aliens are really scary. But Brad is also scared and wants to maintain his savings. But now he has an alternative. With loans only paying 0% interest, Brad is indifferent between loaning to Sarah and simply sitting on cash. So that is what he does, he hoards cash.
But Sarah is trying to save too. She cuts the amount she buys from Brad to repay her loan. The cash Brad receives from loan repayment he sits on, he doesn’t buy any extra Gazzoos from Sarah nor does he loan that money to her. But now Brad’s income has declined (Sarah is buying less of his Widgets). If Brad doesn’t want to reduce his savings, he must also cut his purchases from Sarah, so her income declines too.
Sarah’s debt ratio doesn’t meaningfully change as both the numerator (her debt) and denominator (her income) declines. The only way for Sarah to fix her balance sheet is if Brad is willing to spend some of his savings, allowing her to maintain income. But he’s comfortable sitting on cash at 0%. What he requires to spend more (save less) is a negative interest rate on his money, but the market can’t provide that.
So Brad & Sarah find themselves stuck in the liquidity trap.
What would help them get out of the trap? Inflation, because it creates a negative return on Brad's money and also depreciates the value of Sarah's debts. A third party who was willing to increase their spending on Gazzoos and Widgets would also do the trick, because it would allow Sarah to repay Brad while keeping overall production (income) unchanged. Cutting taxes would be beneficial by allowing Brad to consume more and Sarah to save more. More directly, a third party who was willing to pay Brad to reduce Sarah's loan would work.
What wouldn't work? Higher interest rates and a third party also trying to increase their savings (e.g. government austerity). Deregulating Brad's widget production wouldn't do any good either because Sarah doesn't want to buy any more of his widgets.
Laziness has prevented me from walking through a full-blown example of what I’m talking about, so I suspect much of what I’ve been saying sounds like gobbledy-gook (queue snide remarks from the usual characters). But here goes, for those who have the patience for it:
At the macro level the world is a closed system. Inputs equal outputs. The simplest way to see this is that for every borrower, there is a lender. One person’s debt is another person’s asset. At the macro level, we don’t act in isolation. Your Yin is my Yang.
With that in mind, consider a world with only two people Brad and Sarah. This world has only two products, Widgets and Gazzoos. Brad produces Widgets, Sarah produces Gazzoos and they trade with each other. In this world, GDP equals the total amount of Widgets and Gazzoos produced. Brad uses his Widgets to trade for Gazzoos and vice versa. The more Widgets he produces, the wealthier he is. This is the basis of “Classical” economics, and the underlying rationale to focus on the economy’s “Supply side.”
Now add money and an interest paying bond for savings. Suppose Brad doesn’t want to use all of his income to buy Widgets and Gazzoos? In that case, he can make his extra income available to Sarah, who wants to consume more. Sarah borrows from Brad, and consumes the production Brad doesn’t want. The interest rate charged reflects the balance between how much consumption Brad is willing to forego, and how much extra consumption Sarah wants. Let’s say 5% is the equilibrium rate.
If Sarah decides she’s borrowed too much, she starts consuming less and repaying Brad’s loan. Brad isn’t interested in consuming more when he can lend at 5%, but Sarah wants to consume less if she’s got to borrow at 5%. So the interest rate declines. At 4% Sarah is still willing to borrow and consume, but less than she did before. At 4% Brad is still willing to lend and save, but less than he was before. Output of Widgets and Gazzoos remain unchanged.
Now let’s assume something dramatic scares Brad & Sarah (space aliens?) to the point where Sarah wants to repay her loan but Brad doesn’t want to decrease his savings. Sarah starts trying to repay her loan but Brad wants to keep lending, so interest rates decline further . . . from 4%, to 3%, 2%, 1% and finally down to 0%.
Even when Sarah can borrow at 0% she feels she already has too much debt and wants to pay Brad back. Those space aliens are really scary. But Brad is also scared and wants to maintain his savings. But now he has an alternative. With loans only paying 0% interest, Brad is indifferent between loaning to Sarah and simply sitting on cash. So that is what he does, he hoards cash.
But Sarah is trying to save too. She cuts the amount she buys from Brad to repay her loan. The cash Brad receives from loan repayment he sits on, he doesn’t buy any extra Gazzoos from Sarah nor does he loan that money to her. But now Brad’s income has declined (Sarah is buying less of his Widgets). If Brad doesn’t want to reduce his savings, he must also cut his purchases from Sarah, so her income declines too.
Sarah’s debt ratio doesn’t meaningfully change as both the numerator (her debt) and denominator (her income) declines. The only way for Sarah to fix her balance sheet is if Brad is willing to spend some of his savings, allowing her to maintain income. But he’s comfortable sitting on cash at 0%. What he requires to spend more (save less) is a negative interest rate on his money, but the market can’t provide that.
So Brad & Sarah find themselves stuck in the liquidity trap.
What would help them get out of the trap? Inflation, because it creates a negative return on Brad's money and also depreciates the value of Sarah's debts. A third party who was willing to increase their spending on Gazzoos and Widgets would also do the trick, because it would allow Sarah to repay Brad while keeping overall production (income) unchanged. Cutting taxes would be beneficial by allowing Brad to consume more and Sarah to save more. More directly, a third party who was willing to pay Brad to reduce Sarah's loan would work.
What wouldn't work? Higher interest rates and a third party also trying to increase their savings (e.g. government austerity). Deregulating Brad's widget production wouldn't do any good either because Sarah doesn't want to buy any more of his widgets.
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