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To: philv who wrote (15542)	8/9/1998 12:51:00 PM
From: long-gone	Read Replies (2) \| Respond to of 116781

Heard a bear on Fox News yesterday, he stated that Coke bought at height in 72 regained its value in 85 rh

To: philv who wrote (15542)	8/9/1998 7:08:00 PM
From: Alex	Read Replies (1) \| Respond to of 116781

Japan falls into liquidity trap ROSS GITTINS Don't, say economists, don't economise. They don't invent new theories so much as recycle old ones. When Milton Friedman got everyone excited about the new, gee-whiz theory of monetarism in the 1970s, for instance, he was merely reviving the "quantity theory of money" first enunciated by the English philosopher-economist David Hume in 1752. Now we find the Asian crisis has seen economists resurrecting an old-fashioned concept: the "liquidity trap". If you've spent any time in an economics classroom, you've no doubt heard the term. But it hasn't been used outside the classroom in decades. The idea is attributed to Keynes - though, as with much of what passes for Keynesian economics, it owes as much or more to his disciples. In the textbook world, the economy is caught in a liquidity trap when monetary policy is unable to drive interest rates below a certain level. How could such a situation arise? Because, though the central bank increased the supply of money, that prompted an increase in the demand for money, which prevented the interest rate from falling. At a time when interest rates were already low, there would be an increase in people's demand for money prompted by the "speculative" motive. They'd hold cash rather than buying interest-bearing government bonds because they feared that the next move in interest rates would be up. And if interest rates rose while they were holding bonds, they'd suffer a loss on the capital value of those bonds that would outweigh the interest they'd earned. In such circumstances, the economy is caught in a liquidity trap. Demand is weak, but the central bank is powerless to do anything about it. Keynes made it clear that he regarded the liquidity trap as a "limiting case", something that would arise only in the most extreme circumstances. But that didn't stop his disciples from making it a standard part of the Keynesian model. (They did that because they needed it to support their contention that a fall in wage rates wouldn't return the economy to full employment.) And the emphasis they gave to the possibility of a liquidity trap supported their argument that fiscal policy - the budget - was a much more effective instrument for governments to use to manage demand than monetary policy was. Even today, you can still find echos of the liquidity trap in the view that, though increasing interest rates is an effective way of restricting demand, lowering interest rates is ineffective in stimulating demand. Using lower interest rates to try to get the economy moving, they say, is like "pushing on a string". But though this simple Keynesian model is still taught in many undergraduate economics courses, economic management in the real world has move on. In Australia, as in most developed economies, it's monetary policy rather than fiscal policy that's the main instrument used to stabilise demand. Our Reserve Bank, like other central banks, raises interest rates when it wants to slow things down and lowers rates when it wants to speed things up. And there doesn't seem to be any empirical evidence to support the old fear that lowering interest rates is an ineffective way to stimulate demand. For one thing, in a world of floating exchange rates lowering interest rates will tend to lower the exchange rate. That makes our export and import-competing industries more competitive internationally and, in time, this permits them to increase their production. So the old classroom concept of the liquidity trap has no practical application to the real world. Right? Not quite. The leading American academic economist Paul Krugman - who, in terms of the vigor of his contribution to the public debate about economic policy, bears a striking similarity to Keynes - has observed that a liquidity trap is precisely the predicament the Japanese economy finds itself in. Japan's economy has been going nowhere for most of the '90s and now it's actually going backwards. The economy is so weak there's a real risk that the recession could become a full-blown depression. So why can't the Bank of Japan cut interest rates to stimulate demand? Because interest rates are already so low they can hardly go any lower. Japan's official overnight interest rate is 0.5 per cent (compared with our 5 per cent) and its yield on long-term government bonds is 1.5 per cent (compared with our 5.5 per cent). In a sense, the problem is that Japan's inflation rate is too low. Measured by the CPI, it was zero in 1995 and 1996. It rose to 1.7 per cent in 1997 and is 0.5 per cent at present, but this is explained not by any fundamental inflationary pressure but by a one-off increase in the level of retail prices caused by the Government's (unwise) decision to increase the rate of Japan's value-added tax. In any case, CPIs tend to exaggerate inflation. The truth of the matter is probably that the general level of prices is falling. Certainly, the measure of prices received by producers is falling. So you can see why there's little or no scope for interest rates to be cut further. But if interest rates are already so low, why isn't this prompting people to go out and spend on consumption and investment? Perhaps because Japan is in a liquidity trip in the more literal sense that Keynes identified. Because people regard it as less risky to hold idle cash balances than to invest in new houses and factories at a time when prices are falling. You see now why almost all economists - Keynesian or otherwise - accept that expansionary fiscal policy offers the only means by which the Japanese Government is likely to get its economy going up rather than down. The point to remember, however, is that, as Keynes himself recognised, the concept of a liquidity trap becomes relevant only in the most extreme circumstances. theage.com.au