August 29, 2015    6 minute read

The Threat of a Liquidity Trap

   August 29, 2015    6 minute read

The Threat of a Liquidity Trap

What if we fall into another recession? Have we already run out of solutions? Or is it time to say: are we falling again?

Perhaps those kinds of questions are generated by too much scepticism, however, the current signals of the economy’s status are not as comforting as they could appear at first sight. To be specific three unusual and unexpected events are happening together causing massive sell-off in the equity markets and inducing high volatility, making the whole world tremble.

China

As the People’s Republic of China devalued its currency, the world has had confirmation about signals of China’s decline. As a matter of fact, China is experiencing a serious downturn after its “exploit” consisting in growth rates close to 14%. Moreover, the Shanghai stock exchange has dropped as much as to lose half of its value in the last few weeks (the Shanghai composite went down by 8.5% over the last week) causing a “domino” effect in other emerging markets, in the US and in Europe as well.

The Beijing attempt to shift its internal economic politics from being export-depending to a new model, based on sustainability and internal consumption, as announced for the 13th five year plan, has led to a relevant downward trend in the manufactures exports market. Furthermore, the Chinese economy tends not to be ready for such a change as consumers seems to fear the future, unveiling an adverse behaviour towards current expenses thus paving the way for a major deflation trend. Even though the Government has tried to pump the equity market by pressuring pension and hedge funds to invest, the results are neither satisfying nor appreciable.

composite shanghai

Results will keep being unsatisfactory until Beijing allows its central Bank to implement an expansionary policy in order to spur the equity market instead of undertaking devaluations as has been done.

United States

On the other coast of the Pacific, things are not that better. Despite the continuous announcements by the FED to raise interest rates, the effective implementation keeps on being postponed displaying that the US economy is still not ready to renounce to easy and accessible credit thus revealing that descriptions about the current US’ economy status are optimistic and emphatic.

Why is the US economy not ready?

Increasing interest rates mean lower investments because of the longer time to achieve a sufficient return on the investment; a consistent drop in the real estate market (are we sure that certain territories can afford this?); a sharp fall of consumption of durable goods and above all a reduction in asset prices that will thereby reduce speculation (this is the real Fed’s aim). The rates hike will also determine a big turmoil in the currency exchange market since it will lead to a consistent appreciation of the dollar compared to other currencies. In this way, emerging countries having all their debts in dollars will have to face higher costs in order to repay their debts and they could consequently be forced to undertake additional devaluation of their currencies to make their products desirable (process that has already begun with the Beijing’s decision to devalue the Yuan).

Nevertheless, the stock exchange doesn’t provide any clearer view of the situation. Listed companies are achieving impressive results in terms of quotations being slowed down just by international shocks or fears. An effective example is the Dow Jones index whose current value exceeds the pre-crisis one. The logic consequence and conclusion is that the money central banks have been prompting has been all invested into financial markets or used to repay old debts in a sort of endless spiral towards the high without solid basis. As soon as this basis collapses, millions will be lost and more and more money will be necessary.

It appears that the Fed has to decide between a stop of the recovery (raising rates) and keeping speculation on (keeping rates low and close to zero).

dowjones index

Dow Jones Index (Source: Yahoo finance)

 Commodity markets

Thirdly, the commodity market has been shocked by the Yuan devaluation and by the implicit war among countries and investors supporting the Shale gas and those still relying on crude oil.

Historic oil countries aimed their politics at slipping down prices below the break-even point of the investments in the Shale gas industry in order to make them not profitable and to make negative the ROI of those investments. Furthermore, they have supported environmental associations to slow down shale gas requests pointing out the negative effects of this new technique not based on drilling the land. If their forecasts are right, they will soon be able to raise oil price once again in the near future and to keep being the monopolists. Saudi Arabia provides a glaring example of this silent war. Its current political objective, although the war is fighting in Yemen, consists in keeping low oil prices even though it leads to negative revenues making the State in need of money. It seems that this is the reason why Saudi Arabia has issued its first sovereign bonds since 2007.

Naturally, every countries that relies on oil revenues is suffering a lot and, as said before, the Beijing politics and weakness has made the Brent price fall to $43 per barrel weakening exporter country markets and thus currencies. Even investors in oil companies such as Eni in Italy have to deal with low results and experience conspicuous fall in the equity market.

crude oil

Preserve the “real capital”

The main point consists in trying to avoid any other exceeds of speculation and stop the recent losses in order to try to preserve the “real capital”. International cooperation should be implemented since our world cannot deal with another crisis. All the “extraordinary” measures have been undertaken and there’s nothing else beyond the extraordinary unless a complete annihilation. The Fed has to know when it has to raise interest rates; Beijing should be more open to share with the world its future ideals and ought to be closer to its citizen’s necessities and, eventually, no more implicit wars on commodities could be sustained by our planet.

If one tries to answer the question from the very beginning it is be easy to understand that in case of another tremendous and dire crisis, central Banks will have no power since the world will be stuck into the so called “trap of liquidity” with no possibility to inject liquidity in the markets and implement expansionary policy. At that time the world will be just in the “ hands of politics ” and it will mean going backwards, it will mean regress instead of progress for a society that has experienced the most important crisis in history just a few years ago.

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