Fallacy of Composition: ZLB and Liquidity Trap
For
the sake of convenience, we copy from somewhere else.
(Quote)
Some
macroeconomists claim that households preferably hoard money as a store of
value when the interest rate, or the aggregate level of interest rates, is at
the zero lower bound (ZLB). Fortunately, in the first place, throughout history
all market rates have never at the same time been at or below ZLB, nominal or
effective.
Now, let us think about plausibility
of ZLB. When households are unusually wary about their incomes in the near
future, they may keep all the incremental liquidity from, for instance, the
fiscal helicopter drop (ΔM1).
Fortunately in the second place, there is a silver lining: the fiscal or
monetary authority would seldom bar the household from selling a part of their
asset portfolio for still more liquidity (ΔM2)
when the fiscal drop does not attenuate wariness to a satisfactory extent. As
they act upon the unvaried prospects, prices of some assets will surely drop
down. Then on, some rates of interest certainly rise. This means that the
interest rate of such assets has moved above ZLB.
Further suppose the case when the
households “unanimously prefer liquidity” to assets of all kinds (cf. The General Theory, 1936). Then, the
prices of assets will collapse until there is no trade at all; as a result,
there would be neither prices nor rates. Blessedly, in the meantime, interest
rates must have soared and the liquidity trap disappears on its own right.
In fact, unanimity is the first enemy
of the market. Free and voluntary trade takes place only on the basis of
differences of certain kinds including one in expectations. In reality, in the
first place, there are contrarians such as Warren Buffett who often turn out
afterwards to be more prescient than the majority. Oracles, they are!
Even better, before arriving at
unanimity of any kind, animal spirits of investors will certainly precipitate
the prices of some or most assets with unbearably-low returns. For better or
for worse, on the other hand, there is the famous “fallacy of composition”:
with ZLB present, each can sell the asset out but all cannot. As for all, the only
way out of ZLB is to get out of ZLB as quickly as possible.
As long as the asset market is awake,
the interest rate will scarcely be at ZLB. No sooner weeping for ZLB than
hearing the shout of “No ZLB anymore.” Thank the asset market!
(Unquote)
In
the first place, the market and the economy are organisms. By definition of
organism, where there is an action, there is a reaction.
No sooner the price of a product was
too low, the supply had faded away. Then on, according to the ABC in economics
the price must go up! No sooner the price of an asset approached the sky, the demand
had dried up. Then on, the asset price must come down. According to the ABC in
finance, the lower the asset price the higher the interest rate!
What is true for a party, economic,
social, cultural or political, is not necessarily so to both parties. The
economy everywhere has always two or more hands.
Where is the unanimity?
The Seekers - When
the Stars begin to Fall
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