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Fed Rate Cut Threatens U.S. Economy With Liquidity Trap

December 17th, 2008
One of the most acute dangers to an already fragile economy is the phenomenon referred to by economists as a “liquidity trap.” With the radical reduction in its interest rates by the U.S. Federal Reserve, Nobel Prize winning economist Paul Krugman has warned that this very danger now confronts the American economy, courtesy of the Fed, as it continues to act erratically amidst the worst global economic crisis since the 1930s.
A liquidity trap involves radical rate reductions by a nation’s central bank that translates into virtual zero interest being charged. The result, in a recessionary economy, is that the economic downturn becomes even more traumatic, since a zero rate discourages investment by stakeholders retaining capital. A zero interest rate provides no incentive for long-term investing with its concomitant risk-taking. Those with capital tend to hoard it while an effective zero interest rate is maintained, defeating the stated purpose of such monetary policy, which is to inject liquidity into the economy. In actuality, a liquidity trap prevents liquidity from circulating, no matter what other extreme monetary measures are enacted by the central bank. This phenomenon plagued the Japanese economy during its recent “lost decade.”

Though the New York stock market reacted in a celebratory way to the Fed issuing its effectively zero rate, more thoughtful observers are terrified. This is clearly another panicky response by the Fed, acting out of desperation rather than thoughtful analysis. If America through the Fed’s actions does indeed fall into a liquidity trap, the result will go beyond the severe recession already being forecasted. The likely result will be the protraction of the global economic crisis, with the U.S. economy crippled beyond the worst nightmares of even those predicting another Great Depression.

For the American economy, due to the Fed’s actions, the worst outcome possible is practically assured. The real tragedy is that the radical cuts in interest rates by the Fed under the reign of Alan Greenspan are now recognized as a cause of the mortgage meltdown that led to the current global economic crisis. For Ben Bernanke, current chairman of the Federal Reserve, to replicate his predecessor’s disastrous monetary policies is utterly inexplicable.



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