Yep, This Is What A Liquidity Trap Looks Like

People, businesses, and banks simply aren’t investing in the sense of putting financial wealth to work in productive purposes with the intent to produce goods and thereby produce profits.  Instead, folks, the ones who have financial wealth that is, are just sitting on cash.  They’re putting it in the bank at record low interest rates. The banks don’t want the extra deposits and are trying to discourage it.  Meanwhile the banks are just turning around and putting the money on deposit at The Federal Reserve where it sits idle. This is called a liquidity trap.

Calculated Risk directs us to this report:

From Scott Reckard at the LA Times: Bank deposits soar despite rock-bottom interest rates

Americans are pumping money into bank accounts at a blistering pace this year, sending deposits to record levels near $10 trillion …

In the last three months, accounts at U.S. commercial banks have increased $429 billion, or 10%, almost double the increase for all of last year.

The large amount of cash only adds to expenses such as paying for deposit insurance premiums. … [banks] have slashed interest payments to discourage customers. Wells Fargo & Co. … halved its payments on one-year certificates of deposits to 0.1%; Citigroup … dropped its payment to a paltry 0.3%.

[Some banks are] stashing it in a safe but unrewarding place: Federal Reserve banks, which are paying them an interest rate of just 0.25% to tend the funds. Such deposits rose to more than $1.6 trillion at the end of August from about $1 trillion a year earlier, according to the Fed.

So why is this really significant?  Simple. Neo-classical/neo-liberal macro theories, the theories that conservatives have been relying on, basically say this can’t happen. It’s irrational and according to those models, people and firms never act irrationally.  So who or what theories say a liquidity trap is possible?  Keynesian theory.  Yes, the whole idea of a liquidity trap in which macro circumstances are such that firms and households would rather hold cash than put it to some productive investment purpose comes from Keynes.

A liquidity trap is also significant because it means that monetary policy, the raising/lowering of interest rates and the purchase/sale of bonds by the central bank, isn’t very effective in a liquidity trap. The Federal Reserve can make funds available for investment, but it can’t force banks to lend or firms to invest or households to spend.  Monetary policy in times of a liquidity trap has been likened to pushing on a string.  The string doesn’t really move much.  Again, neo-classical models don’t allow for the possibility of a liquidity trap.  Indeed they start with assumptions that pretty much exclude the possibility of there ever being one.  Models and theories that start with the assumption that “A” can never happen aren’t of any use in trying solve “A” when it really does show up.

Why do people seek money instead of useful investment in a liquidity trap?  Simple. There are two reasons why firms and people would seek to hold financial wealth as money instead of useful, profitable investments.

  • First, profitable investments require a growing economy and expectations of a growing economy.  If firms and people have no confidence that the economy will grow or that any growth will last, then they don’t invest. No need to expand capacity at the business if you won’t need the extra capacity.
  • Second, if you expect the economy to get worse and/or have deflation happen, then it makes enormous sense to be cash instead of things.  Cash actually is profitable and gains in real purchasing power when deflation happens.  So I would interpret from the above data that people, banks, and firms are expecting more deflation and not expecting inflation.

What to do in a liquidity trap?  Theoretically (and Krugman/Delong push this idea)  you could have the central bank (Federal Reserve) make some sort of commitment to higher future inflation.  But that’s in theory only.  It’s not been proven.  What’s experience say?  We have a choice.  Suffer through it, experience a prolonged depression that could easily last a generation, and make do with lower living standards for the vast majority but see the really wealthy become even more wealthy.  This is the story of the Long Depression in the late 1800’s.   Or, we could turn to aggressive fiscal policy. Keynesian style spending for job creation.  That’s been proven.  It worked in the 1930’s until it was abandoned in 1937, it worked in 1939-1940 with the start of WWII (not my choice of spending priorities), and it worked quite well in the 1950’s through the 1970’s in achieving a higher average annual growth rate in GDP than has been achieved since.

Unfortunately, too many economists, and the politicians that follow them, are so married to their ideologically-based models that they persist in the theory even when the facts contradict it.

9 thoughts on “Yep, This Is What A Liquidity Trap Looks Like

  1. Nicely put, Jim.

    Our monetary policy has failed by giving bond holders more of what they didn’t want in the first place, while fiscal policy has suffered from debt terrorism. Unfortunately, those that could make the needed fiscal adjustments are so uninformed that they actually think the US Gov’t can go bankrupt.

  2. A very clear explanation defining a liquidity trap and why we have one now. Thanks.

    You suggested in your conclusion you suggest that we might loosen the trap if “we could turn to aggressive (government) fiscal policy. Keynesian style spending for job creation. That’s been proven.”

    There is a question in my mind whether Keynesian macroeconomics as practiced by the United States government is effective and the right move this time around.

    When I look at ARRA data I don’t see any relationship whatsoever between ARRA’s actual Keynesian style spending and GDP growth or job growth.
    ( )
    ( )

    The Q2 2009 GPD growth spike and its diminished after effects in later quarters had to have been triggered by TARP loans, not ARRA. TARP loan spending was in full swing in late 2008 and early 2009.

    Logically, TARP is the only government program that could be credited with preventing a full scale depression. ARRA came along to late for that.

    By the time ARRA’s serious money, tax changes and directed economic activity took root the economy was already on the skids again and its real spending generated no significant GDP growth or job growth to speak of.

    If it had we wouldn’t be talking “stimulus II” right now.

    It makes me question whether it is wise to do more of the same thing again and hope for a different result second time around. That doesn’t make logical sense.

    I think a fault in Keynesian macroeconomics as practiced by the U.S. government is that government is quick to spend money, but never pays off it’s Keynesian acquired debt during good economic times like it should.

    That coupled with wars, bad policy decisions and just plain bad fiscal management by multiple administrations has helped us acquire a ginormous $14.7 trillion national debt monster that is growing by about $3.8 billion every day.

    Just since Obama took office government has spent $4.1 trillion more than it has taken in. It has further degraded the fiscal positions of entitlements and the “payroll tax holiday” has actually accelerated the demise of Social Security. Now government proposed to weaken Social Security still faster with an even bigger “tax holiday”.

    How much more deficit spending must there be before we finally figure out that deficit spending, Keynesian or otherwise, is hurting more than helping?

    • azleader –

      I posted this on the Stimulus thread about the Q2 GDP boost….


      “So, where did the boost come from? A reduction in the trade deficit and government spending.
      Trade acted as a boost to GDP in the second quarter, adding 1.38 percentage points. U.S. exports fell by 7.0% and imports decreased 15.1%.
      Spending by the federal government in the second quarter rose 10.9%, after declining 4.3% in the first quarter.”

      As the prof says, it depends on where you spend, and how much. I would add “when” to that. If you wait till things get too bad, you convert lots of spenders to savers, and savers don’t add much to the velocity of money. Tax cuts only help those that are getting a paycheck and business wants to see customers with demand backed by cash, otherwise they’re savers too.

      And how about those falling interest rates? That pulls money back out of the economy (interest channel income). Looks like that dropped about 68 Billion from 2008 to 2009. US individuals and institutions were getting over 40% of that, over 60% if you count Gov’t and GI retirement funds and SSI.

      So did the Gov’t do a fair job of replacing the missing money and getting it in to the right hands? Not so hot. Wrong amount, wrong timing, wrong distribution.

      • Thanks for your quick response. I really appreciate it.

        I’m struggling to understand these things.

        I now get it that the Q2 boost came from reductions in the trade deficit and government spending before ARRA came along. That makes perfectly reasonable sense.

        One thing is certain… the boost DIDN’T come from ARRA spending and that was my independent conclusion based on the timing and quarterly amounts of ARRA spending once it got cranked up.

  3. Jim,

    Another reason that households and businesses hold on to cash. They expect things to go worse, and fearing reduced incomes in the future, hold on to the cash so that they will be able to make the necessary expenses to stay alive today and till the financial assets last.

    In those circumstances spending on nothing but the absolute necessities is what happens.

    Take for example a household. If I have savings, i will hold it in liquid or semi liquid safe financial assets so that I can pay for food and rent further down the road. Food taking priority over rent, as long as there is some place to go to. It makes little sense to buy large amounts of perishables, rather than hold on to the cash for future purchase. Neither does it make sense to pay a years rent in advance. Holding on to cash allows you more options than otherwise.

    • That’s why it’s best to step in early with stimulus in such situations. I hate to cast a vote for the “Confidence Fairy”, but earlier is better here. Cascades like this, with so much collateral damage, really show how inept fiscal policy just compounds the problem. As the damage strikes closer to home, those on the fence convert from a spending bias to a saving bias and node after node follows suit, putting more and more money to sleep. A stitch in time…

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