The Foolproof Way

In his 2003 paper Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others Lars E.O. Svensson describes his Foolproof Way of escaping from a liquidity trap — experienced by countries such as Japan, and lately the US, when central bank interest rates are close to zero.

The Foolproof Way consequently consists of announcing and implementing three measures: 1) an upward-sloping price-level target path, starting above the current price level by a price gap to undo; 2) a depreciation and a crawling peg of the currency; and 3) an exit strategy in the form of the abandonment of the peg in favor of inflation or price-level targeting when the price-level target path has been reached.
As discussed in the previous subsection, a currency depreciation and a crawling peg is unique in providing the central bank with a concrete action that demonstrates the central bank’s commitment to a higher future price level, establishes credibility for the peg, induces private-sector expectations of a higher future price level, and stimulates the economy by reducing the real interest rate. As argued, via a depreciation and a crawling peg with a rate of appreciation approximately equal to the average foreign interest rate, the central bank can actually implement approximately the optimal way to escape from a liquidity trap and strike the optimal balance between current stimulus of the economy and the future price level. Furthermore, as discussed, the exchange rate is unique in providing a relatively direct measure of the private-sector expectations of the future price level.

5 Replies to “The Foolproof Way”

  1. Colin
    This paper is an excellent example of why the financial system is in trouble. In my humble opinion it complete nonsense and I defy any to explain in plain English.

    1. It was a struggle for me to get through the paper and my conclusion echoes yours. First of all, a 2003 paper is sorely outdated to explain the violent economic convulsions since 2008. Second, all governments/central banks (the US leading the pack as usual in any financial skulduggery) have been manipulating inflation statistics through a variety of tools, such as composition of the CPI basket, weights assigned to components and methodological fiddling. Real inflation rates are far higher than those claimed by governments as any ordinary person shopping for essentials like groceries or toiletry can attest. Third, governments, central banks and economists like Krugman have forgotten what they were taught at school –the elementary function of money as a medium of store, i.e., preserving its value over time. All this talk of ‘controlled inflation’ is so much baloney to cover up a runaway situation of one’s own making that one can no longer control.

      1. The financial system is in trouble because of excessive debt growth over the last two/three decades. Now we face the consequences: a debt contraction that will lead to a deflationary spiral similar to the 1930s — where US production halved and GDP fell by 30% — unless strong measures are taken to counter this. The only reason we are not already there is because of massive fiscal deficits run by most developed economies: public sector borrowing to offset private sector deleveraging. The risk is that they will end up in the same place as Japan, with enormous public debt and no end to the deflationary pressure.

        I think we all agree things should never have been allowed to get this far out of control. But that is spilled milk. Central bankers have to come up with a solution: how to prevent a deflationary spiral while private sector debt contracts. This paper discusses available options and proposes one of the better solutions I have seen.

        Monetary policy is the lesser of two evils. Like chemotherapy it should only be used when the patient is critical. The problem is that central bankers for the last few decades have been prescribing the stuff like aspirin.

        But when the economy does need it — during a banking crisis — don’t go for half-measures. Rather overshoot than undershoot the target.

  2. Well, Colin, we both know where we are coming from. Monetary policy is one of two legs that got us here. Printing more money to pile up more debt sounds awfully familiar. That’s pretty much what was done in the past. Since when is a disease a cure for itself? As to whether we shall go down in a deflationary death spiral or go up in a flame of hyperinflation, only time shall tell. One can keep stalling the day of reckoning only so far and no farther. Japan, by the way, isn’t a good example. You have stated the reason yourself. Think Iceland. Too insignificant, you say? Jesus thought otherwise when he said: out of the mouth of babes and sucklings thou hast perfected praise. Let me stop there without citing Einstein’s quip on insanity.

    1. “As to whether we shall go down in a deflationary death spiral or go up in a flame of hyperinflation, only time shall tell.”

      If Bernanke gets it wrong. What he is trying for is both — so that we pass through the eye of the hurricane.

      Luckily there is no limit on the number of metaphors per post 🙂

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