Economic theory has advanced so much that the Keynesian-Monetarist dichotomy is blurred. Economists today can think freely about fiscal policy (with monetary implications) and monetary policy (with fiscal implications) interchangebly. In the end, spending and pumping money into the system are quite the same however you dice it. The illumination from Keynes has been to be able to accept deficit-spending as a way forward. The unfortunate thing is that Keynesian policy has reached its limits apparently, because of limits placed on government deficits by buyers of government debt. The Japanese answer to this debt limit is to bypass private debt purchasers and just ask the central bank to print.
But what I really want to discuss in this blog is Keynes' famous concept of the Liquidity Trap. This is economic psychology. The economic assumption has been that when people have money, they will either spend the money on food or buy a guitar or save it and invest it in bonds or equities or buy a house. Somehow, by putting more money into the system, people will spend or invest and somehow generate economic activity. Under normal circumstances, monetary policy works. By lowering the interest rate, people borrow more and spend and get the economy going. In the process, money is created.
The Liquidity Trap kicks in when people suddenly become fearful of the uncertain future, and they start holding onto cash. This happens they expect prices to fall - no point buying now when things can get cheaper later and get a bargain. The Liquidity Trap comes in when deflation is expected to happen or is already happening. It's like catching a falling knife. When there is a Liquidity Trap, lowering interest rates do not work to stimulate the economy and this is when governments have to spend and arrest the decline in prices.
For years, governments have been arguing for stimulus packages in order to kick start a depressed economy and get inflation going. This is jolly well and good. Now, the problem is when stimulus packages are no longer virgin policies and they have been used and abused for decades. Prices run off and people are happy making tons of money without too much hard labour except speculating on shares and properties in the comforts of a cozy office.
In the past, banks used to be responsible especially after having gone through the recession of the thirties and the inflation of the seventies. Banks were prudent and had their internal checks and balances. Most banks were owned by private individuals, with a personal stake in its fortune. By the eighties, many banks went from European/UK type to US type banking where the CEOs were and are just employees out to make a quick buck from their bonuses calculated on loan disbursed but not necessarily repaid. An untrained banker can become very rich by blindly giving out loans and targeting high loan growth. The only thing you need is a collateral and collaterals can be created everyday if you are giving out loans for properties.
When the game of rapid loan growth funding property purchases hit its limit when there are no more housebuyers, the mortgage market gets into trouble. Because deposits of the public is at stake, government stepped in to save banks and this can be done if the property market is not allowed to adjust downwards. Property prices are kept up and loans kept on the books but there is no extra cash to lend to other users like businesses. The banking system gets caught in a quagmire.
Governments print money to save banks from collapsing. There is no threat of inflation. In this case, there is a threat of deflation from property prices. It is this threat of asset deflation that is being used as a justification by central banks around the world to print more money in an effort to the save the economy.
With property asset prices being kept up, rental prices continue to be high. Housing prices remain unchanged; they may even rise as more money is being pumped into the system and banks try to show a profit with more loan growth. Those who do not own their homes still have to rent and pay high rentals. Businesses pay for high rentals of their shoplots. For the ordinary people, food prices continue to be high as the global commodity markets go crazy on biofuels and natural disasters as well as on sustained growth in China and India.
The unfortunate case of Japan today given the earthquake should give Malaysians a stark lesson in economic efficiency. It is really not a clever argument to say that economic efficiency is not important. The natural disaster requires that scarce resources of the Japan government has now got to be re-deployed into replacing what is lost rather than build more on what already exists. All additional resources will be used to recreate new towns and new villages and new facilities. But for the Japanese, all will not be lost. They will rebuilt a new system which will be far more superior from what they had lost. What they have now lost in structure will now be replaced with greater efficiency. Japan will recover, and it is the efficiency and determination of its people that they have my greatest respect as economic creatures.