Liquidity Trap, Examples with Five Signs and Five Cures

Why the Fed Must Raise Interest Rates

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liquidity trap exists when there's a lot of capital in the economy, but the funds are 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. Treasurys. In other words, the Fed uses expansionary monetary policy to stimulate the economy.

A liquidity trap occurs 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 is credit thanks to lower interest rates. When the Fed pushes the gas pedal, it doesn't rev up the economic engine. Instead, businesses and families hoard their cash. They don't have the confidence to spend it, so they do nothing. The economic engine is flooded.

Top Five 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. But 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.

Five Solutions

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

First, the Fed raises interest rates. 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.

Second, prices fall to such a low point that people just can't resist shopping. 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.

Third, an increase in government spending. That creates confidence that the nation's leaders will support economic growth. It also directly creates jobs, reducing unemployment and hoarding. 

Fourth, financial innovation creates an entirely new market. That happened with the internet boom in 1999. 

Fifth, governments coordinate global rebalancing. That's when countries that have too much of one thing trade to those that have too little. For example, China and the eurozone 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, such as the Middle East and Latin America, should send them to countries with an aging population, like Europe and the United States, so they can become productive.