According to economist John Maynard Keynes:
“A liquidity trap is an economic condition that can occur when interest rates fall so low that most people prefer to hold cash rather than invest it in bonds and other debt instruments.”
Just a couple of years ago, in 2020, the COVID-19 pandemic rocked the global economy to its very core. The World Bank described it as “triggering the largest economic crisis in more than a century.” In response, central banks of different countries around the world have slashed interest rates and injected trillions into the economy in an attempt to restore normalcy.
Five years after that major event, the International Monetary Fund claims the global economy is on track, but it is not yet out of the woods, as growth remains sluggish in some countries.
This uncertainty raises a key question: What if monetary policy simply stops working? Economists call this a liquidity trap, and it’s a problem that can stall economic recovery and frustrate policymakers.
In this article, we’ll explain what a liquidity trap is, examine real-world examples, unpack how such traps occur, and explore possible escape routes.
Let’s get started.
What Is Liquidity Trap?
A liquidity trap is an unusual economic situation that occurs when investors and consumers prefer to hoard cash rather than invest, even with low interest rates (typically when interest rates are close to zero).
To understand this, it helps to first clarify the term liquidity. Liquidity refers to how quickly and easily an asset such as stocks or property can be converted into cash without significant loss in value.
More and more people are recognizing the importance of this concept so much so that “liquidity meaning in Hindi” is now a commonly searched phrase online. This reflects a growing interest in understanding how liquidity influences the economy.
In a liquidity trap, however, people prefer liquidity so strongly that they hold onto cash instead of investing, which undermines the usual impact of low interest rates.
A liquidity-trapped economy is often characterized by:
- Low interest rates (close to zero)
- A preference for cash hoarding by the general public
- Slow economic growth
- Deflation
- Ineffectiveness of traditional monetary policies
This economic concept was discovered originally by J. M. Keynes and Hicks (1937), and it later became a major hallmark of Keynesian macroeconomic theory.
Normally, monetary policymakers like central banks set low interest rates to incentivize investors and customers to take loans and funnel such funds into investments that’ll ultimately boost the economy. However, when there is a liquidity trap, the opposite happens.
Despite the prevailing low interest rates, people and businesses simply don’t want to borrow or venture into investments. They would rather hold on to the amount of money in their possession. Consequently, all expansionary monetary policies, such as further lowering the interest rates or increasing the money supply, implemented by policymakers tend to be unable to stimulate the economy.
So, why would the general public prefer to hoard cash rather than put it into investment vehicles?
It’s pretty simple: they’re anxious about future events!
Some of the following reasons usually cause liquidity traps:
- Anticipated economic recession
- Lack of profitable investment opportunities
- Low confidence in the economy
- Near-zero interest rates
- Deflation or deflationary expectations
- General preference for liquidity
These are some of the core factors that trigger a liquidity trap. Let’s examine them in detail below.
How Liquidity Traps Occur
Several events occur in an economy before it eventually falls into a liquidity trap. Some of them include the following:
1. Interest Rates Reach the Lowest Limit
A liquidity trap starts to brew when the short-term interest rates are so close to zero, so much so that it is virtually impossible to reduce them further. Whenever an economy has low interest rates without a corresponding increase in consumption and investment, the economy runs the risk of falling into a liquidity trap.
This eventually happens when the central bank of a given economy consistently reduces the interest rates for a prolonged period.
2. Money Demand Declines and People Start Hoarding Cash
Investors, businesses, and members of the public start to lose interest in taking more loans or investing their cash when interest rates have been consistently low for a prolonged period. Instead, they develop a preference for liquidity by hoarding cash.
Members of the economy prefer to keep their money rather than risk it due to different concerns. For instance:
- Consumers and households hoard cash because they expect further deflation or more adverse economic conditions.
- Investors avoid long-term bonds because they expect little or even negative yields
- Banks find it difficult to lend money due to smaller margins.
3. Deflation or Deflationary Expectations Peak
Deflation is a general reduction in the price of goods and services. This economic condition occurs for various reasons, one of which is declining money demands due to public speculation.
The rationale behind this is that households and investors expect prices of goods, services, and investments to continue to fall, and so they choose to delay purchases and investments.
When this downward price reaction to the economic condition peaks, it may result in a liquidity trap.
4. Expansionary Monetary Policies Fail to Lower the Interest Rates
Expansionary monetary policies (when the central bank increases the money supply to boost liquidity) through different measures tend to prove futile in easing economic conditions. This is because investors and consumers would just rather hold on to their cash.
The same applies when central banks try to lower interest rates further. Lower rates are relatively inconsequential if people would rather save their cash than invest or lend more cash.
The Dangers of Falling Into a Liquidity Trap
When an economy enters a liquidity trap, businesses, investors, and households are bound to face some negative consequences and risks. The following are some notable dangers of falling into a liquidity trap:
1. Reduced Investment Opportunities in Businesses
Businesses in an economy that’s in a liquidity trap generally attract little or no investments from investors. This is because the prevailing economic conditions make investors doubt the business’s profitability potential.
Furthermore, with consumers spending less, businesses realize lower profits and are consequently forced to conserve their resources.
This lack of investment deepens the economic slowdown, making recovery harder and ultimately resulting in a vicious cycle that’s increasingly hard to get out of.
2. Economic Stagnation and Recession
Liquidity traps trigger a prolonged period of slow or near-zero economic growth.
When consumers and businesses consistently reduce spending and borrowing, the economy runs a risk of ultimately shrinking. If drastic measures or changes are not implemented, the economy has a high chance of experiencing negative growth.
3. Reduction in Bond Market Investments
Liquidity traps can also trigger low demand for bonds.
Bond prices and interest rates have an inverse relationship. Bond prices are at an all-time high when interest rates are at their lowest, which is usually the case during liquidity traps. So, investors generally stay away from bond market investments during liquidity traps due to the high investment prices.
Furthermore, they speculate that bond prices will reduce when interest rates increase again. So, they simply wait it out.
4. High Unemployment Rates
It’s almost natural for prolonged periods of high unemployment rates to follow periods of economic stagnation and reduced investments and spending. In a bid to conserve their resources, businesses start imposing employee cuts and salary reductions.
5. Ineffective Monetary Policies
The usual expansionary monetary policies, like the altering of interest rates, which the policymakers usually use to prop up the economy, suddenly start becoming ineffective. This condition leaves the monetary policymakers feeling powerless over the economy.
6. Increased Government Debt
The government often resorts to extreme measures like direct bank transfers to regain some form of control and steer the economy in its desired direction. These extreme measures, however, can plunge the government into debt accumulation, which may further stifle long-term economic growth.
Historical Examples of Liquidity Traps
Historically, liquidity traps often happen after significant region-wide crises like the COVID-19 pandemic, Japan’s real estate crisis, or the great depression.
Let’s examine some of the most significant liquidity trap economic conditions in history.
1. The Great Depression of the 1930s in the USA
In the mid-1930s, short-term nominal rates in the US were continuously close to zero.
This event is one of the most famous historical cases of a liquidity trap. The Great Depression of the 1930s was a worldwide economic downturn that began in the United States and lasted from 1929 to 1939 when World War II commenced.
During the Great Depression, the following are some major occurrences that marked the era as one of the most significant liquidity traps.
- The United States experienced a very low average inflation rate of about -6.7%. In fact, it wasn’t until 1943 that this inflation rate returned to 1929 levels.
- Nearly one-half of bank suspensions occurred due to heavy withdrawals, signifying a prevalent preference for liquidity.
- Banking failures occurred as banks recorded a high volume of non-performing loans – loans that cannot be repaid.
- Production cuts and high unemployment rates were the order of the day.
2. The Lost Decade in Japan
The ‘Lost Decade’ in Japan refers to a decade-long period between 1991 and 2001 in which Japan experienced consistent economic stagnation and price deflation.
The Japanese economy was initially strong in the ‘80s, as evident by a 3.89% GDP compared to 3.07% in the US. In fact, Japan recorded the largest per capita Gross National Product (GNP) in the world in the ‘80s. However, the economy took a different turn in the fall of 1989 when the Bank of Japan (BoJ) stopped the money supply in accordance with their agreement with other world nations in the Plaza Agreement of 1985.
Economists believe this singular act may have played a vital role in the equity and real estate bubble burst that ensued. This burst caused equity values to crash by 60% from late 1989 to 1992, while land values kept dropping throughout the ‘90s. Consequently, Japan averaged a GDP growth of only 0.5% in the following years.
In an attempt to revitalize the crashing economy, the Bank of Japan initially tried raising interest rates. While this move marked the end of rising land prices, it also pushed the economy into a downward spiral. So, when the BoJ noticed this downward spiral, it decided to reverse its initial move and cut the interest rates.
However, Keynesian economists like Paul Krugman opined that Japan had been caught in a liquidity trap, as Japanese households and investors were already deciding to sit on their cash. This was because they had little or no faith that they could earn a higher rate of return by investing and that prices would soon come crashing down due to deflation. This lasted for the next ten years, and Japan’s economy stagnated.
How to Escape a Liquidity Trap: Policy Options for Governments
According to research findings by Willem H. Buiter and Nikolaos Panigirtzoglou at the National Bureau of Economic Research (NBER), two of the most effective means of escaping a liquidity trap include:
- Expansionary fiscal policies
- Lowering the zero nominal interest rate floors
1. Expansionary Fiscal Policies
Expansionary Fiscal Policies are a coordinated series of macroeconomic policies that use budgetary instruments to encourage economic growth by raising spending and cutting taxes.
The goal is to ensure consumers and investors have more money to invest (increase the money supply). Additionally, it aims to reduce unemployment, raise consumer demand, and ultimately stop the recession.
Some of these measures include:
- Imposing tax cuts on wages and corporate income
- Introducing subsidies
- Recruiting new government employees
- Contracting public works to members of the public
- Increasing government spending
- Transfer payments
Governments can escape a liquidity trap through a combination of these expansionary fiscal policies. However, they must be implemented effectively to see results.
2. Lowering the Zero Nominal Rate Floors
Lowering the zero nominal rate floor means allowing nominal interest rates to fall below zero into negative territory, ultimately making it costly to hold cash.
Here’s the idea.
When interest rates are fairly normal (significantly above zero), there’s really no incentive to hold cash (and not spend it) because cash yields zero interest. The implication is that households and companies have a reason to spend and invest.
However, during a liquidity trap, the interest rates are now at zero and even approaching negative. So, people would rather (logically) hold their cash and not borrow. But that’s bad for the economy on a larger scale.
In response, monetary policymakers can decide to incentivize spending by allowing nominal interest rates to go below zero. This effectively means making it costly to hold money by imposing a small tax on holding money, called taxing money. This effectively reduces the lower bound, pushing nominal rates into negative territory.
Conclusion
Clearly, understanding liquidity trap is crucial because, although such traps are rare, they represent real-world challenges capable of grinding massive, healthy economies to a halt.
And even when central banks and monetary policymakers are pulling out all the stops, there is a good chance that they may be unable to reverse things quickly when an economy gets caught in that ‘trap’.
From the Great Depression to the aftermath of COVID-19, history shows us that when people and businesses lose confidence, even the most powerful monetary tools can lose their magic.
As such, understanding how liquidity traps work, why they happen, and what it takes to escape them isn’t just a matter for economists; it matters for anyone who cares about jobs, growth, and the future of the economy.
As the world continues to navigate uncertain waters, observing these warning signs and being open to bold solutions could make all the difference.
