Liquidity Trap: Examples with 5 Signs and 5 Cures

Why the Fed Must Raise Interest Rates

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A liquidity trap occurs when people hoard cash instead of spending or investing it. Photo: Charles Bowman/Getty Images

Definition: A liquidity trap is when there's a lot of capital in the economy, but it's not used for investment or spending. Instead, it's hoarded or used for non-productive activities. As a result, low-interest rates and easy money don't translate into healthy economic growth, well-paying jobs, and higher prices. In other words, the demand needed to drive the economy is lackluster.

The Federal Reserve is in charge of managing liquidity with its monetary policy.

To boost economic growth, it lowers interest rates to encourage borrowing and lending. It lowers short-term interest rates with the Fed funds rate and long-term rates with open market operations that buy U.S. Treasuries. For more, see Expansionary Monetary Policy.

A liquidity trap usually happens after a severe recession. Families and businesses are afraid to spend, no matter how much credit is available. 

It's like a flooded car engine. When you push the gas pedal, the car goes. But if you've already pumped the pedal, and released gas into the engine, you've flooded it. The more you continue to pump the pedal, the more you flood the motor. You've got to stop and let the gas evaporate before you push the pedal again.

That's what happens in a liquidity trap. The Fed's "gas" -- more credit thanks to lower interest rates -- doesn't rev up the economic engine. No matter how much the Fed pumps the pedal, nothing happens.

That's because businesses and families hoard their cash. They don't have the confidence to spend it, so they do nothing. 

Top 5 Signs

How do you know if you're in a liquidity trap? Weird things happen. First, businesses don't invest in expansion. Instead of buying new capital equipment, they make do with the old.

They take advantage of low-interest rates and borrow money, but they use it to buy back shares and artificially boost stock prices. They might also purchase new companies in mergers and acquisitions, or leveraged buy-outs. These activities boost the stock market, but not the economy

Second, businesses don't hire as they should, so wages remain stagnant. Without rising incomes, families only buy what they need, and save the rest. Low wages aggravate income inequality. 

Third, consumer prices remain low. Without inflation, there's no incentive for families to buy now before prices go up.

Fourth, you might even get deflation instead of inflation. People will put off buying things because they know prices will be lower later.  Many people do that now with big purchases. They wait until the holiday shopping season and Black Friday for lower prices they know are coming. 

Fifth, banks don't increase lending. They are supposed to take the extra money the Fed pumps into the economy and lend it out in mortgages, small business loans, and credit cards. However, if people aren't confident, they won't borrow. Furthermore, if banks aren't confident, they will keep the extra cash the Fed gives them.

They'll either write down bad debt or increase their capital to protect against future bad debt. They might raise their lending requirements, as well.

5 Solutions

Five things can get the economy out of a liquidity trap.

  1. Interest rates rise. An increase in short-term rates encourages people to invest and save their cash, instead of hoarding it. Higher long-term rates encourage banks to lend since they'll get a higher return. That increases the velocity of money. (Source: The Liquidity Trap, St. Louis Fed.)
  2. Prices fall to such a low point that people just can't resist snapping it up. It can happen with durable goods or assets like stocks. Investors start buying again because they know they can hold onto the asset long enough to outlast the slump. The future reward has become greater than the risk.
  1. Increased government spending creates confidence that the government will support economic growth. It can also create jobs, reducing unemployment and hoarding. 
  2. Financial innovation can create an entirely new market. That happened with the internet boom in 1999. 
  3. Coordinated global rebalancing between countries that have too much of one thing to those that have too little. For example, China and the euro zone have too much cash tied up in savings. That's a result of consumer spending in the United States on Chinese exports. China must invest more in the United States to get that money back into circulation. Similarly, countries with lots of unemployed young people (Middle East, Latin America) should send them to countries with an aging population (Europe, United States) so they can become productive. (Source: "Exit, Pursued by Bear," The Economist, January 2, 2016.)