Liquidity Trap with Causes, Signs, and Cures

Why the Fed Must Raise Interest Rates

liquidity trap
•••

Illustration by Dan Stipple/Getty Images

liquidity trap is an economic situation where people hoard financial capital instead of investing or spending it. As a result, the nation's central bank can't use expansionary monetary policy to boost economic growth. It often occurs when short-term interest rates are zero.

Causes

Central banks are in charge of managing liquidity with monetary policy. Their primary tool is to lower interest rates to encourage borrowing. That makes loans inexpensive, encouraging businesses and families to borrow to invest and spend. It's like stepping on the gas to increase the engine's speed. When you push the gas pedal, the car goes.

The U.S. central bank is the Federal Reserve. It lowers short-term interest rates with the fed funds rate. It lowers long-term rates with open market operations that buy U.S. Treasurys.

 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. You've released so much gas into the engine that it crowds out the oxygen. Pumping the gas pedal doesn't help. You've got to stop and let the gas evaporate before trying to start the engine.

That's what happens in a liquidity trap. The Fed's gas is credit and the pedal is 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

For a liquidity trap to occur, interest rates must be low. The fed funds rate is at zero. If it's been there for a while, people believe that interest rates have nowhere to go but up. When that happens, no one wants to own bonds. A bond bought today that pays low rates won't be as valuable after interest rates rise. Everyone will want the bonds issued then because it pays a higher return. The low-rate bond will be worth less in comparison.

Second, 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.

Third, companies 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

Fourth, consumer prices remain low. Without inflation, there's no incentive for families to buy now before prices go up. You might even get deflation instead of inflation. People will put off buying things because they know prices will be lower later.  For example, people delay making big purchases until the Black Friday sales. 

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. When 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.

Examples

Japan's economy is in a liquidity trap. Its interest rates are near zero and the central bank buys government debt to boost the economy. But it doesn't work. People expect low rates and low prices, so they don't have the incentive to buy now. Without demand, businesses won't hire as many additional workers. Pay remains stagnant. The central bank has done as much as it could.

Japan's government has promised to change other aspects of Japan's economy that create stagnation. Guaranteed lifetime employment reduces productivity. The keiretsu system gives manufacturers monopoly-like power. That reduces free market forces and innovation. Japan's population is aging, but granting citizenship to young immigrants is discouraged. Until these curbs to growth are addressed, Japan will remain in a liquidity trap.

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.

 

The Bottom Line

A liquidity trap occurs when people don't spend or invest even when interest rates are low. The central bank can't boost the economy because there is no demand. If it goes on long enough it could lead to deflation. Japan's economy provides a good example of a liquidity trap.

There are five ways out of a liquidity trap. The two most workable depend on the nation's central bank and the federal government. The central bank could raise rates and trigger inflation. The government could spend more and instill confidence.