Empirical evidence prooving Liquidity-trap: Lower interest rate does not stimulate economy

Why is the economic recovery not stimulated even though the central banks offer the sizably low interest rate which is close to zero? Many people imagine that if the interest rate is low, the economy should be stimulated. The reason is that the cost for companies paying the interest rate of their debt and for entrepreneurs planning to borrow money to start their new business is low.

However, this is only the microeconomic factor, which is a static analysis focusing on the individual economic agent's performance, and does not take account of the time effect and the environment interacting with this agent's performance. This means it ignores the macroeconomic factor which is the dynamic analysis taking account of the future expectation and the wide scale economic environment.

The problem is that, even though the interest rate, the cost of borrowing, is low, if the expected return from investing to economy is low, banks and the other forms of financial institutions are reluctant to lend their money. In addition, the entrepreneurs are discouraged from borrowing money to invest to their business if the future expectation is not good for their business due to the current economic environment.

This phenomenon is called the "liquidity-trap" which was originally mentioned by Professor John Maynard Keynes. During the world economic depression in 1929, many economists thought the economy would be eventually recovered if the central bank tried to increase the liquidity of money supplied by lowering the cost of borrowing money. However, this expectation did not happen. Keynes analysed this problem by explaining the liquidity of money was stuck in their flow due to the lack of confidence in investment. Keynes also put emphasis on need of the price inflation to increase the investment volume. If the price inflation is taking place, the real value of the money borrowed at a certain past time period goes down, and the nominal value of the revenue gained at each time period keeps increasing (the real value of the revenue is kept almost constant). By contrast, if the price deflation (i.e. the "minus" inflation) occurs, the financial economic situation is the opposite effect of the inflationary period.


This project assessed whether positive or negative the correlation between the interest rate and the investment share of GDP. London Interbank Offered Rate has been newly introduced by the IMF, WEO Database, Country Data recently so this newly introduced variable was used as the variable representing the interest rate. Although, there are only the US and Japanese one for London Interbank Offered Rate, the USA and Japan are the best candidate countries to assess the effect of the liquidity trap because they are experiencing now! In addition this variable is a very useful indicator of the interest rate effect on economy because this interest rate index takes account of the various money transactions between various banks and the other forms of financial institutions.

* "London Interbank Offered Rate" is denoted as "the interest rate" and "the nominal interest rate" in this project.

* There are two indicators of the investment share of GDP. One is "the percentage investment share of GDP times the (natural) log of GDP", and another is "the (natural) log of the GDP times the percentage investment share of GDP"

* All the logalisms used in this project is the natural log.

* These OLS regression analyses are based on the fixed effect model which involves the dummy variables (the binary variable) for the different units (countries).

* The variable called "Time" denotes the time trend whose valometer increases as the time passes.

First of all, the simple Ordinary Least Squares (OLS) regression analysis was run. The investment share of GDP is regressed on the logged interest rate. The result offered is shown in the figure below:


This OLS regression is the percentage investment share of GDP times the (natural) log of GDP:




This OLS regression is the (natural) log of the GDP times the percentage investment share of GDP:



These results show that the positive correlation between The investment share of GDP and the interest rate. It is really disappointing for those who trust the monetary policy of both the current US Federal Reserve Bank and Bank of Japan. It is also surprising for many microeconomic financial analysts because it indicates that the business grows when the cost of borrowing and the interest payment on company-debt is high. This contradicts the basic static ( = nominal) cost and benefit analysis. Thus, these results affirm that we certainly need a complex dynamic ( = real ) cost and benefit analysis.

Is it logical to say that "We should rather increase the interest rate to recover our economy?" No, this is not logical. It is not logical to say "Higher the cost for companies and entrepreneurs is, higher the confidence of consumption and investment is".

This aspect suspects that the interest rate is not exogenous (the condition to be a good explanatory variable not being controlled by any other factors (variables)) so that it can be endogenous (controlled by some other factors. This situation leads the analysis inconsistent if this endogenous variable is used as an explanatory variable).

There is an international financial economic theory stating that the interest rate is given by the exogenous factor we are hardly able to control rather than we give the interest rate to control the economic situation. This theory suggests that the interest rate is set according the price inflation rate to make the real interest rate (the nominal interest rate minus the price inflation rate) to as zero as possible. Therefore, this theory rejects the classical and the monetarist theory of the interest rate which states that the low interest rate lowers the cost for the entrepreneurs i.e. stimulating the economy. This theory claims that the interest rate is an indicator of the price inflation. It means that, when the interest rate is high, the expected rate of the price inflation, which increases the business opportunities, is high.

* This is the theory in the developed economies where the hyper-inflation risk caused by the mal-fiscal functioning tends to be low.

All in all, there is a room to assume that the inflation rate stimulates the investment share of the GDP. Therefore, it tested if the logged investment share of GDP is positively correlated with both the interest rate and the logged price inflation rate (In the later texts, the price inflation rate is written as the inflation) as follows:


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This proves that the inflation is positively correlated with the investment share of GDP. However, there is a concern that the interest rate and the inflation are correlated each other. If the explanatory variables in one OLS regression are correlated each other, it tends to disturb the OLS analysis result.

So, it suggests to assess the endogeneity of the explanatory variable. By following Keynes' theory and the theory claiming the interest rate is given, the interest rate is assumed to be positively correlated to the inflation. This inference also claims that the Two Stage Least Square (TSLS) regression analysis, instead of the OLS, to regress the investment share of GDP. The first stage regression, which is called the "auxiliary regression", to regress the interest rate, the candidate explanatory variable of the investment share of GDP, on the inflation, the instrument variable of the interest rate, the explanatory variable.

The other reason why the inflation is wanted to be used as an instrument variable and the interest rate is wanted to be used as an instrumented explanatory variable is that this project attempted to explain the whole mechanism explained by the theory and assess if this theory actually proves the real world economic situation. Because it assumes that the interest rate is highly controlled by the inflation. Therefore, the inflation had to be used as an instrument variables so that it cannot be used as one of the explanatory variables.


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These results proved that the inflation is positively correlated with the interest rate as the theories suggest.

The fitted value of the interest rate instrumented by the inflation rate (and Time if necessary) was saved to use for the second stage regression, which is the primary regression of the TSLS analysis.

There are two analyses because "the percentage investment share of GDP times the (natural) log of GDP" and "the (natural) log of the GDP times the percentage investment share of GDP" are assessed a little bit differently. The former one was regressed on the interest rate instrumented by both the inflation rate and the Time meanwhile the latter one was regressed on the interest rate instrumented by the inflation rate only.

Both kinds of regression analyses are based on the non-linear model because there is assumed to be the optimum interest rate affected by the optimum inflation rate which maximise the investment share of GDP. The positive but reasonable rate of the inflation is a indication of the circulation of economic activities running well and the economy is expanding not too fast. However, the positive and high inflation rate decreases the real value of individual economic agents' income, and discourages saving, the source of financial economy, and supply of the investment available (The net present value of the amount of money invested declines over time). In addition, as the (nominal) interest rate is determined by the inflation rate (in order to set the real interest rate (the interest rate minus the inflation)). Therefore, in order to find the optimum inflation rate and then the optimum interest rate (= The intercept + Coeff. x "The inflation" + error) are required to find out!


The regressions below are "the percentage investment share of GDP times the (natural) log of GDP" on the interest rate instrumented by the inflation and the time trend:


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According to the three criteria (denoting the smaller number shown by each criterion implies the better model), the regression above without including the time trend as one of the explanatory variables is a better model than the other with the time trend as one of the explanatory variables. This reason would be because the time trend is already included in the instrument variable of the interest rate.

The other sorts of models with various kinds of formulae, such as the liner model ( I = a + b x R + error) and the cubic formula ( I a + b_1 x R + b_2 R^2 + b_3^3 + error ), are regressed. Nonetheless, the square formula (The second degree formula) came up as the best model to demonstrate the correlation between the investment rate times the GDP. By observing the both models above, both formulae has the global maximum value. Therefore, this result indicates that the optimum interest rate instrumented by the inflation rate exists.

The figure below contains the matrix graph (the top one) showing what the interest rate given by the inflation and the year is, and the other (the bottom one) showing what "the percentage investment share of GDP times the (natural) log of GDP" given by the interest rate instrumented by the inflation and the time trend is:



These graphs indicate the following phenomena:

# The real interest rate (the gab between the interest rate and the inflation rate) tends to be minimised as the year (Time) passes.
(This could be considered because of the global financial liberalisation which has increased the degree of competitiveness of the global financial market. )

# The optimum interest to stimulate the economic activity is between 1.77 and 2.14.

# In 1980 (and possibly before), the high inflation is discouraged the economic activity level more than the low inflation.

# In 1990 and after, the lower inflation discourages the economic activity level far more than the high inflation.


The regression below assessed "the (natural) log of the GDP times the percentage investment share of GDP" with the same method as "the percentage investment share of GDP times the (natural) log of GDP" assessed in the previous regressions.



For "the (natural) log of the GDP times the percentage investment share of GDP", the interest rate is only instrumented by the inflation because this model needed to include the time trend as one of the explanatory variables. This reason is because the dependent variable "the (natural) log of the GDP times the percentage investment share of GDP" is increasing over time so that the regression model had to involve the explanatory variable explaining this factor. It also had to exclude the time trend from the instrument variable of the interest rate in order to avoid including one same variable for two different indicators.

The figure below contains the matrix graph (the top one) showing what the interest rate given by the inflation and the year is, and the other (the bottom one) showing what "the (natural) log of the GDP times the percentage investment share of GDP" given by the time trend (Exogenous) and the interest rate instrumented by the inflation is:



These graphs indicate the following phenomena:

# The optimum inflation rate stimulating the economic activity is 2.48, and the optimum interest rate is 1.5 then.

# Lower the interest rate is implies lower the economic activity level is.



Having observed these results given by the regression analysis (based on the fixed effect model), the sizably low interest rate is less likely to increase the liquidity of the money supply flowing into economy. As Prof. Keynes suggested, the USA and Japan may need to expect the exogenous shock in their economy, such as technological growth and finding a new natural resource and/or a brand new invention, and/or the strong positive planning policy intervention other than the monetary policy.

All in all, the policy makers cannot merely control the interest rate to expect the economic recovery. Hence, the current US and Japanese monetary policy seems to be very unreliable to stimulate the economic recovery.

Gold bubble is less likely because of the high money demand (Low Liquidity)

There is a concern of the gold bubble. But, it has been predicted that the gold bubble is less likely to happen.

The reason why is that the money demand is still high in global market compared to 1970s, the period that the gold bubble occured. In 1970s, the real value (taking a consideration of the price inflation (The relative depreciation of the money, and the relative appreciation of gold)) of gold became significantly higher than the nominal value of gold. In 2011, the real value is not significantly high, and it is same as or even lower than the nominal value. This is because of the deflation which implies the relative appreciation of money to the value of goods&services.

When the marginal increase of the gold value becomes closer to zero, the investors stop switching converting their saving from the money to golds. This prediction is less likely in the hyper-inflationary situation. This situation occurs due to the "deflation" which takes place when people save rather consume goods&services and/or invest to capital. The demand of money is still high (i.e. the liquidity of money is low) so that the effect of the substitution between the money and gold is low.

The cause of fall in demand of national currencies is the prediction that the value of these national currencies may be depreciated in the near future i.e. the possibility of the hyper-inflation which is the rapid appreciation of gold's real value. However, this is now seen as a speculation. Although the credit rating of some advanced countries went down and there is a concern of collapse of European economy, the USA does not seems to be bankrupt, and the European central bank and government seem to rationally tackle with this crisis. All in all, both the USA and Europe do not seem to be destroyed. The rich investors still save both US-dollar and Euro so that the governments and the central banks will still keep their financial resource well.

There is always a peak in any price rise as long as the financial market is liberalised. There is a limit of investers who are able to convert their wealth into gold. Nobody cannot save their income only by consuming gold. Therefore, when the volume of gold consumed reaches at the limit, the over-speculation of purchasing gold will end.

Rather than the gold bubble and the depreciation of credit rating, fall in the real market in this globe is a bigger problem. Too many investors save their income rather than spend. The gold bubble will end, and the money in the advanced economies will not be significantly depreciated. However, all the income is stuck as saving. They save their income by converting it to the money kept in bank or gold. In order to overcome this global recession, the liquidity of money into the real economy has to increase.

The gold bubble is less likely, but the perpetuation of this world recession is more likely...

Lower Credit Rating = Higher the Risk Premium = Higher Interest Payment

The credit rating tends to be determined by the frequency of trade of this national debt. Long (buy) = higher the rate; Short (sell) = lower the rate. This decline in the credit rate means rise in the risk premium so that the interest payment has to go up. The investors (the saving curve) requires higher security on investment to the government (the investment curve): The saving curve shifts left along the investment curve. Therefore, the quantity traded goes down, and then the value of this share goes down...

Socialism is an arrogant theism without God, and the reason why socialism is wrong

* This is actually published on 28th of June, 2012

The situation that Einstein became popular is just a coincidence. Just his existence and the demand at the contemporary time period matched with each other. Well, we cannot control over the "luck" at the time, place, and occasion we are born. This is one of socialists' characteristics I cannot trust: Socialists seem to attempt to control "luck" as though they were God. That's why socialism is called as the theism without God or with the alternative God as the mechanism of human-beings. I found socialism is very arrogant ideology more than any other religion.


* Speaking of what capitalism is, and Hegelian historical point of view:

The word "capitalism" is what socialists call as an antonym of socialism. There is no such a thing like capitalism: There can be what we call as Comprehensive Liberalism (Classical Liberalism). Dr. Ron Paul says "The system socalled capitalism has never been established yet".

I strongly disagree with Hegelian historical perspective (Social Conflict theory) which socialists follow. I do not see individuals' perspective and community structure dramatically change at a certain point to "evolve". I would say individuals' perspective and community structure change "gradually", and all of them work as "functionally" at the optimum level the technology available offers. I really detest that socialists always expect our future must always become better. If we adapt such a perspective, we eventually need to be disappointed by our past and present. In addition, I hate socialists for ranting on "society" the abstract metaphysics we cannot see and even we cannot access whether or not it exists! Their call on society kills individualism and introduces totalitarianism! I hate socialism!


* The reason why socialism fails, and is detested:

I also researched about non-authoritarian socialism such as syndicalism, social-democracy, Neo-Marxism, etc. But, I am still not convinced by socialism at all. The common failures of all kinds of socialism are (1) it fails to mention the fact that natural resource is limited, and (2) it tends to think human-beings are genuine and able to cohabit without any hesitation. (1) indicates that, if we try to attempt to accomplish the equal distribution and providing the basic standard of living for all, the resource will run out eventually. In order to avoid this situation, the population has to be declined at the feasible level, all individuals have to strive to obtain the resource in the severe competition, and/or someone (An individual or a government) or social norm (Tradition, Principle, etc) has to enforce the distribution (The distribution can be either unequal or makes everyone equally poor though). This results in the situation that what socialists try to accomplish is impossible to achieve. (2) indicates that socialists always think human-beings can become genuine and cohabitabe in peace after the battle between two classes ends. This is way too optimistic perspective. It fails to demonstrate how we can differentiate the reward and the punishment for individual. Someone can produce more than others, someone can be more generous than others, someone can be wicked but may be able to bring a productive consequence, someone can bear too many children beyond their responsibility available, and someone can violate liberty of others. We then need a fair judgement to distribute the reward and the punishment. Furthermore, I really detest the word of "fellow men" because it infers altruism. The notion of fellow men is very dangerous because it encourages homogeneity, cooperation (Dangerous if excess), and solid social norm. We only need a minimum right for all, carelessness about what all individuals think, believe, and behave, and some public goods and aids which only applies as much as these individuals previously invested to and as long as all individuals agree by means of their egoistic interest meets with the service provided.

Well, I think neither I am particularly superior to majority nor I belong to an elite cohort of human-beings. Nonetheless, I feel really awkward to be unconditionally looked after by someone I am not related, and I despise the community structure which either enforce or suggest us to unconditionally spend to those whom we are not related and those whom we despise so much. Only whom I want to care are myself and my family (related family members, my significant other, and those almost like my family). I want all people in this globe to be emancipated to become rationally egoistic individuals. Then, our wealth (not only monetary but also non-physical those who we inherit through family and culture) will not be sacked by a propaganda motivated by a superstitious abstract terminology such as society, public, and nation! We always want to make sure that we spend for those we can see and those which are objectively and explicitly valued as a fair exchange of values.

The International Monetary Fund (IMF) is necessary and its necessity is inevitable

* This article refers to The Wall Street Journal
JUNE 17, 2011, 3:53 P.M. ET
IMF Cuts Growth Forecast for Global Economy .

I understand how angry the IMF is due to the bad discipline of the EU fiscal policy and the retarded attitude of all national governments in this globe...! I believe the IMF should intervene into both monetary and fiscal policies of all over the world because the world economy has already become globalised. Economic regions in all over the world is now too contingent to avoid focusing on the global economic political censorship by the global financial institute...!

I assume that the IMF "wanted to expect" the USA and the EU to install the right policy as the IMF suggested. I guess, this does not mean the IMF miss forecast; the IMF crackdowned to say these economies will be endangered because they did not listen to what the IMF said! This is the way, the IMF always change the prediction. I have recognised that the IMF economic prediction is rather subjective than objective. But, I do not say it is a bad thing; it is a strong indicator of what the IMF judges. I have more faith in the IMF than any national sovereign any way...



Do you know who said we needed the IMF? John Maynard Keynes, and I support his idea! So, I am not a fundamental monetarist although the national sovereignty in all over the world should be abandoned. This is not due to the political ideological issue (J. M. Keynes was actually an economic pragmatist), it is the "accountability" and "responsibility" issue...! It is a "natural evolution" of economy! As economy becomes globalised and contingent each other, the market (Nature! Geometrical fact!!) needs a global mediator. I am not for a world government, but I am for a world financial liberalisation!!

Difference between 1929 and 1990s, and 2000s-10s

Yeh, the scale of banks' bankruptcy was much smaller than the current banks' bankruptcy, not so many Friedmanites realised. In 1929, Friedman's claim of temporary money supply for rescuing these private banks may have worked because the bankruptcy occurred because of the fear of people assuming banks could bankrupt.

By contrast, 1990s and 2000s are the entirely different problem!

The financial crisis in 1990s was based on the immaturity of Asian financial institutional policy. I agreed with Stiglitz that these Asian financial institutions were not mature enough to let run independently. He claimed that the IMF should have had a great role to induct them, and more the foreign direct investment from the advanced nations should be injected into.

The ongoing financial crisis is tremendously much more problematic than these previous world financial crises! This problem also involves the "financial accounting" which allows institutions to involve the aggregate market value of the assets investment they have purchased which is their potential gain from asset investments (This is called "Unrealised Profit" in the pure cost accounting because it cannot be simply shown in the balance sheet based on the "Cost Total System" which is based on the total sales revenue minus the total cost).

Before the late 1990s, the financial law in majority of nations did not involve the aggregate market value of their shares purchased. However, from the late 1990s and early 2000s, the financial law in all the advanced nations started allowing involving any potential gain from asset investment. This change in the financial law dramatically changed the attitude of financial institutions in the advanced nations. All these financial institutions started to purchase a lot of shares. This resulted in that, although the profit comes from the total sales revenue subtracted from the total cost is smaller or even loss, the book involving the potential profit (the current value of share minus the value of share when it was purchased) shows the profit is huge.

The opposite case scenario of this financial accounting is Chinese government. Nowadays, Chinese profit based on the sales revenue minus the total cost is higher than the profit based on the aggregate market value because the value of all the foreign currency and all the national debts of the advanced nations, which Chinese government has purchased in the past to depreciate Chinese currency, become depreciated dramatically.

Therefore, unlike in 1929, the central bank could not predict the adequate volume of money supply it should have poured into the market to rescue these banks involved in this activity to increase the "aggregate market value" of their total asset investment. Some of the shares these financial institutions are foreign, different industries, and toxic. Therefore, although I would support Friedmanite bank rescue program in 1929, I am deeply sceptical about his theory applied in the current crisis. Many socialists tend to blame capitalism. But, I would rather blame the national authorities who regulate the financial accounting law. This problem is way beyond the central banks' responsibility and accountability on their loss.

If it were based on the accounting based on the revenue coming from the pure monetary saving and investment, yes Friedmanite policy should have applied. However, this problem highly involves the mal-management, which Friedman should have said there needed a strict crackdown on these financial institutions.

As a matter of fact, one of my lecturer in my MSc in Strathclyde uni was Friedmanite, and he highly criticised the current global financial market situation. He strongly disagrees with the Euro, the sub-prime loans (He said that such a private sector business involving the risk of bankruptcy should not have taken place), and the over-expansion of the current banking system.

Furthermore, the current financial recapitalisation was done by the fiscal policy rather than the monetary policy which Friedman insisted to use.
I know Friedman would have supported rescuing banks by the excess money supply, but some guys would say that it was Friedmanite policy to rescue these banks having involved in race of increasing their aggregate market value. However, if there are a violation of equity, such as the fiscal policy to rescue these mal-managed institutions by using the innocent tax payers' money, and the problem is beyond the accountability of central bank such as the ongoing financial crisis, the responsibility of monetary policy is very limited, Friedman would have said if he follows his original role.

Speaking of Hayek, I am more likely to detest Hayekian than follow. Hayekian theory strongly insists the importance of "tradition" and "traditional moral guide line" (I really despise them!) which Hayek defined as a key to stabilise economic and social order. In addition, Hayek is morea political philosopher than an economist, I would say, meanwhile Friedman is a pure mathematical economist. Hayekian ethics follows the school of Natural Law as same as Edmund Burke. This is why Hayek humiliated Friedman as an anarchist.

This is why Hayekian theory can be also applied to European Social Democracy seen in Germany and Scandinavian nations. Hayek did not particularly support free market economy nor fundamental reconstruction of economic structure unlike Friedmanite. Furthermore, the huge difference between Hayek and Friedman is that Hayek was deeply sceptical about Macroeconomics whilst Friedman put emphasis on Macroeconomics. As a matter of fact, North Western European economic policy is highly microeconomics, and hardly regards of macroeconomics. Hayek would be happy with the continental European economic policy, which is yet Socialistic and has installed the common currency, whereas Friedman would be upset about and against the current continental European economic structure...!