Follow Us:
Thursday, May 28, 2020

Paul Krugman says the liquidity trap has spread to emerging markets

The so-called liquidity trap, when monetary policy loses its traction as interest rates get close to zero, has plagued rich countries for years. Nobel-Prize winning economist Paul Krugman says it has now spread to some emerging markets as well.

By: Bloomberg | Published: May 12, 2020 4:59:51 pm
Nobel Prize-winning economist Paul Krugman (Image source: Bloomberg)

Two months into the deepest slump in decades, some of Latin America’s major economies are close to losing their main recession-fighting tool — interest rate cuts.

Peru and Chile have already lowered borrowing costs almost to zero, and are being forced to consider new tactics to rescue their crashing economies. Brazil and Colombia may soon be in the same boat.

The so-called liquidity trap, when monetary policy loses its traction as interest rates get close to zero, has plagued rich countries for years. Nobel-Prize winning economist Paul Krugman says it has now spread to some emerging markets as well.

“There’s nothing about the logic of a liquidity trap which says it can’t happen in a developing country,” Krugman said in a May 8 phone interview.

(Chart source: Bloomberg)

Peru’s central bank last week said it’s ready to use different types of monetary stimulus to sustain demand during the coronavirus pandemic, while Chile’s has started buying bonds issued by banks. But measures of this kind are a much less effective form of stimulus than simply cutting the policy rate, according to Krugman.

Dollar Debt

Many developing nations are facing the current disaster with low inflation and modest levels of dollar debt. This makes them less vulnerable to a traditional emerging market crisis, in which a sell-off in the currency triggers an inflationary spiral or makes it harder to service overseas debt. Instead, they’re facing a whole new set of headaches.

“If we’re looking at Turkey or Argentina, they’re experiencing relatively classic sort of emerging market crises with a cut off of capital inflows,” Krugman said. “But a lot of the emerging world has made a lot of progress on those issues, and the perverse thing is that by gaining some sort of first-world style credibility, they’ve managed to make themselves vulnerable to first-world kinds of problems.”

When the global financial crisis hit Latin America 12 years ago, central banks in Brazil, Colombia, Chile and Peru all slashed interest rates by five percentage points or more. That’s not an option this time.

When the pandemic struck, all four countries had a policy rate below 5%. Now they range from 0.25% in Peru, to 3.25% in Colombia. Some of the region’s smaller economies, such as Paraguay and Guatemala, also now have rates near to zero, as do several emerging markets in Asia and Eastern Europe.

Mexico, the only major economy in Latin America that still has interest rates significantly above the rate of inflation, is also cutting fast, with another half-percentage point reduction forecast this week.

Fiscal Stimulus

While countries such as the US, the UK and Japan have “enormous leeway” to borrow money for stimulus programs, due to their long history of being reliable debtors, emerging markets are more restricted in their ability to use fiscal stimulus, Krugman said.

“If I were a finance minister in an emerging market I might call for some, but I’d probably be nervous about doing it on the kind of scale that we’re seeing in Europe and the US right now,” he said.

Chile, with lower levels of debt and a longer history of being considered credible, has “vastly more room for maneuver” than Brazil has, according to Krugman.

1930s Depression

The British economist John Hicks, a follower of John Maynard Keynes, formulated the theory of the liquidity trap in the depression conditions of the 1930s. Economists didn’t have to worry about it much in in the half century after World War II, when rates were well above zero.

Krugman played a key role in making the idea mainstream again in the 1990s when he wrote about how policy makers failed to revive Japan’s depressed economy after borrowing costs sank close to zero. The US and the euro region cut rates nearly to zero after the 2008 global financial crisis.

Whatever handicaps they face in fighting the current downturn, emerging market policy makers should try not to make things even worse, Krugman said.

“At the very least these countries can try to avoid the historic pattern of pro-cyclical fiscal policies, and actually doing fiscal contraction at the same time that their economies are slumping,” he said.

📣 The Indian Express is now on Telegram. Click here to join our channel (@indianexpress) and stay updated with the latest headlines

For all the latest Business News, download Indian Express App.

Advertisement
Advertisement
Advertisement
Advertisement