AFTER the Brexit referendum and the election of Donald Trump, and the subsequent market reactions, I think we are closing in on a decent theory of the way liquidity traps end.
That might be going too far. Markets have not had that much time to process the American election outcome, and what time they have had has sent some mixed signals. Yet among the clearest market moves since the morning of November 9th has been a sharp drop in Treasury prices, accompanied by a sharp rise in implied inflation expectations as determined from inflation-protected Treasury securities. Now: sharp is relative. But markets are showing signs of that they expect reflation under Mr Trump. And they have reason to. Mr Trump seems keen on massive tax cuts and a big increase in government spending (on defence, and perhaps also on infrastructure). Mr Trump might just represent macroeconomic regime change.
Let’s back up. The theory of liquidity traps first began to develop in the 1930s, when John Hicks picked up where John Maynard Keynes left off, in response to events of the Depression. Keynes explained that when an economy was operating at less than full employment, then a rise in government…Continue reading