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The Concept Of A Liquidity Trap Economics Essay


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"Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."- John Maynard Keynes

By the mid-1990s, most macroeconomists had assumed that the concept of a "liquidity trap" was dead and buried. As Krugman (1998) noted that most of the modern papers which dealt with the topic conclude "liquidity trap can't happen, it didn't happen, and it won't happen again". However, it did happen and even affected the mighty Japan.

In theory an economy is said to be in a liquidity trap when the monetary authority cannot achieve lower nominal interest rate in order to stimulate output [1] . Such a situation can arise when the nominal interest rate has reached its zero lower bound (ZLB), below which nobody would be willing to lend. Even if the monetary authority increases money supply to stimulate the economy; people hoard money. In other words conventional monetary policies become impotent because base and bonds are viewed by the private sector as perfect substitutes (Krugman 1998). Liquidity trap usually is caused by, and in turn perpetuates deflation [2] (Hiro Ito 2008). When deflation is persistent and combined with an extremely low nominal interest rate, it creates a vicious cycle of output stagnation and further expectations of deflation.

The great recession of late 2000s sparked many debates about the possible existence of a liquidity trap in US. Nobel Laureate and a CEPR Research Fellow Dr Paul Krugman is one of many Keynesian economists who believe that the Great Depression has drifted US into a liquidity trap. In order to assess this viewpoint we need to analyse the economic indicators which encompassed the great recession.


One of the most important economic indicators to assess the impact of the recession is the Gross Domestic Product. Figure 1 shows that during the first half of 2009 industrial production fell by almost 10% as compared to same half of last year.

Figure 1


In fact, industrial production index fell by almost 25 index points (base=2007). In addition, analysis also reveals that construction spending, another critical indicator of output, shows fall throughout the period. These indicators do point towards the fact that output was stagnant through this recession.

The great recession was also absorbed by stagnation in retail sales and consumption. From figure 2 we can clearly see the drop in retail sales during the recession period which characterises a perfect freefall.

Figure 2*


This is important because retail sales are an indicator of consumer spending which makes up more than two thirds of GDP. In fact, figure 3 shows that personal consumption decreased by 3.4%.

Figure 3


This is particularly interesting because the US has never seen a drop in personal consumption [4] since the great depression; even during the recession of 2001, personal consumption never showed signs of slowing down. This is important because characteristically a liquidity trap exhibits inadequate demand even with ZLB.

On the other side, personal savings rate which has been declining for the last 15 years rose from a mere 2.6% to almost 7%.

Figure 4


Personal savings grew from $300 billion to $900 billion by the end of the recession. Credit card use, which makes up about 40% of consumer borrowing, also fell by 5%.

Part of the decrease in the personal consumption and industrial production can be attributed to the inflation rate and expected inflation. Figure 5 shows that although there was an increase in CPI (consumer price index) in the beginning of the recession, eventually there was disinflation [5] which transformed into deflation.

Figure 5


This is also related to and in fact influences the inflation expectations people form [6] . It is important to note that as people form their inflation expectations (or in this case deflation expectations) they try to delay consumption so that their purchasing power is greater in the future. This leads to rounds of delayed consumption, which results in lower production because of positive real interest rates in a liquidity trap. Inevitably this results in rise in unemployment because of stunted investment. All of these ingredients play a major role in defining a financial situation as a liquidity trap.

However one last piece of information which solves the puzzle is the interest rate prevailing in the economy. If we analyse the interest rate figures which were prevailing in the economy during the recession, it is fairly obvious that easy money has been tried and that the continued sluggishness of the economy shows that it has been ineffective.

Figure 6


Figure 7


The 10-year bond rate has been till very recently 2.5 %( it is now 3.4%). The Fed Funds rate is virtually nonexistent at the current rate of 0.18% (and has been since the last quarter of 2008). This becomes particularly alarming if we compare these figures to the savings and the consumption figures quoted earlier. The recession period shows inverse relationship of interest rates with personal savings and a direct relationship with consumption. These two facts point towards the existence of a situation similar to, if not exactly, the liquidity trap explained above.

In the General Theory Keynes mentions about the liquidity preference in these words:

"...There is the possibility … that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control..." [187].

Whether we define the great recession in terms of the liquidity preference Keynes set forth or by the modern definition Krugman explains as:

"...Injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes."[1998, 5]

We can safely conclude that by each of these definitions the great recession did slip US into a liquidity trap. Many may argue otherwise but by the textbook definitions which we gave earlier, the results are quite convincing towards the possible existence. Even if an expansionary monetary policy had not yet been tried, the near-zero interest rates experienced by US would prevent any future easing of monetary policy from having an impact on spending. Regarding the great recession, Krugman may be wrong in some instances but he was more right than wrong. The above conditions do show that the US economy was in a paradox of thrift where desired savings exceeded desired investment.


Given all that we have argued, what are options for the policymakers to react to such a trap and how well would they work? Current discussion focuses on three basic alternatives

- Fiscal Expansion: This was first suggested by Keynes (1936) as a remedy to the liquidity trap. His advice was that the government can always stimulate the economy in a liquidity trap by simply printing money. Krugman also supports this policy and in fact he proposes an even stronger fiscal stimulus than the current one along with an aggressive GSE lending [7] . Some economists have even suggested undertaking a "helicopter drop" (Friedman, 1969, pp 4-5) targeted at the Treasury.

However there has been criticism on the US fiscal policy as the unemployment rate is much higher despite the fiscal stimulus. To this policymakers have responded saying had it not been the fiscal stimulus the final numbers would have been much worse. On the other side Krugman feared that the fiscal stimulus was just too small in the first place given the large recessionary shock. There have also been debates about the fiscal multiplier and the relative effectiveness of tax cuts and government expenditure but research is ongoing and we will only get to know the findings later.

- Unconventional Monetary Policy: As interest rates touch zero, central Bank needs to adopt policies other than lowering interest rates. The first set of such policies implemented by the fed during the recession was the "Qualitative Easing" under which the fed reallocated its asset portfolio [8] . It replaced risky assets from the market with Treasury bonds in its balance sheet. The idea behind this option was to reduce risk spreads and encourage market-making in markets where trading had collapsed.

"Quantitative Easing" was another option pursued by the fed after the collapse of Lehmann brothers. The focus shifted to purchases of Treasuries (USD 105 bn per month in gross terms until June 2010) financed by monetary creation. As a result balance sheet expanded significantly. Fed assets jumped from USD 907 billion on 3-Sep-08 to USD 2.2 trillion on 12-Nov-08 and Bank Reserves from USD 10 billion on 3-Sep-08 to USD 859 billion on 31-Dec-09 [9] . However in theory quantitative easing is inefficient because money and default risk-free bonds (Treasuries) become extremely substitutable in a liquidity trap.

Another policy which has emerged as a very important tool is the "Central Bank Communications". The Fed can give a forward guidance to the markets about the Fed's future policy moves and guides financial markets by releasing certain statements. For example "The fed likely to warrant exceptionally low levels for the federal funds rate for an extended period". Krugman is also a supporter of this "pre-commitment" by the Fed to keep rates low for an extended period.

"Inflation Targeting" is another tool to tackle the liquidity trap by creating expectations. For example if the Fed announces to keep the preferred inflation estimate around 2% (core PCE) then it will lead to higher inflationary expectations and will lead to rise in industrial production and eventual decline in unemployment rate. Svensson is a strong proponent of this policy. However such a policy is difficult to implement given the present Federal Reserve Act. A variant of this strategy is the "Price Level Targeting" under which there is a commitment to raise prices over a certain period rather than a commitment to raise prices every year by the same rate. The issues related with this strategy are the same as inflation targeting. Only Sweden tried it during the great depression and research shows good results.

"Exchange Rate Targeting" is another policy which suggests that Central Bank in coordination with government can take measures to depreciate the home currency. This would lead to more expensive imports and result in higher inflation. This would also push up demand as exports become cheaper compared to other countries. However this option cannot be tried in these current market conditions as there are many countries facing the same problem of liquidity trap and it will lead to protectionism and currency wars.

- Money financed Fiscal Stimulus: In this case, government starts fiscal stimulus which is financed by Fed using quantitative easing. Recent research paper by Meyer suggests that this will lower unemployment in US by 2% by 2012 and inflation will rise by 0.5% by 2013. However this hybrid of fiscal and monetary policy has the same issues regarding the idea of an independent central bank aiding a government borrowing program.

Final thoughts

An effort has been made in this essay to analyze the difficulties a central bank faces during a liquidity trap and discusses the tools and options available to monetary policymakers. Policy as usual is not an option, and the central bank's framework for conducting policy must change. Importantly, it must change in ways that alter individuals' expectations of what policy will be like when the zero lower bound on interest rates is no longer binding. Thus, the conduct of monetary policy becomes quite subtle and depends on the credibility of proposed future actions. Furthermore in the case for US, Quantitative easing seems to be the right option. However the best solution would be a coordinated fiscal and monetary policy. Paul Krugman commented on the lowering of the Fed rate to 0-0.25% in these words: "seriously we are in very deep trouble. Getting out of this will require a lot of creativity, and maybe some luck too." Looking at the evidence I must say that it will surely require a lot of luck.

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