Here’s a good discussion of what liquidity traps are from John Hussman. His weekly market commentary begins:
"There is the possibility… that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control."
John Maynard Keynes, The General Theory
One of the many controversies regarding Keynesian economic theory centers around the idea of a "liquidity trap." Apart from suggesting the potential risk, Keynes himself did not focus much of his analysis on the idea, so much of what passes for debate is based on the ideas of economists other than Keynes, particularly Keynes’ contemporary John Hicks. In the Hicksian interpretation of the liquidity trap, monetary policy transmits its effect on the real economy by way of interest rates. In that view, the loss of monetary control occurs because at some point, a further reduction of interest rates fails to stimulate additional demand for capital investment.
Alternatively, monetary policy might transmit its effect on the real economy by directly altering the quantity of funds available to lend. In that view, a liquidity trap would be characterized by the failure of real investment and output to expand in response to increases in the monetary base (currency and reserves).
In either case, the hallmark of a liquidity trap is that holdings of money become "infinitely elastic." As the monetary base is increased, banks, corporations and individuals simply choose to hold onto those additional money balances, with no effect on the real economy. The typical Econ 101 chart of this is drawn in terms of "liquidity preference," that is, desired cash holdings, plotted against interest rates. When interest rates are high, people choose to hold less cash because cash doesn’t earn interest. As interest rates decline toward zero (and especially if the Fed chooses to pay banks interest on cash reserves, which is presently the case), there is no effective difference between holding riskless debt securities (say, Treasury bills) and riskless cash balances, so additional cash balances are simply kept idle.
Edward here. This is another thought-provoking piece from Hussman to which I have linked at the bottom. I have been thinking about this from government’s angle since it is clear the US government is destined to print a lot of money due to the aversion to more deficit spending. Last November, I wrote a post called "On debt monetization" which went into a bit of this.
Normally, the U.S. Treasury must sell bonds when there is a budget deficit. The principal reason that the Treasury could not just print money out of thin air (what Murray Rothbard calls counterfeiting) is because the Federal Reserve needs them to control supply and demand of Fed Funds in order to maintain its target interest rate above the interest rate on reserve balances.
However, when interest rates are zero percent, the Federal Reserve doesn’t have this problem. There is no difference between the Fed Funds rate and the rate on reserve balances.
When the Fed Funds rate is essentially zero, the Federal Government does not have to issue any bonds at all (except as mandated by Congress to ‘fund’ deficit spending). In reality, when rates are zero, the Fed could simply monetize the deficits and it would be functionally equivalent. What this means is that there is no difference between quantitative easing and issuing short-duration treasury bills. Paul Krugman recently pointed this out in an essay, saying:
The point is that we’re now in a liquidity trap. What does that mean? It means that the Fed has pushed short rates down to zero, so that at the margin T-bills are no better than cash — and correspondingly, that means that at at the margin people and banks are holding some of their cash purely as a store of value. Liquidity is now free, and as a result the market’s demand for liquidity is satiated; adding more potentially liquid assets makes no difference. So issuing short-term debt and printing monetary base are equivalent.
But, you say, it won’t always be thus: at some point the economy will recover to the point where the zero lower bound is no longer binding; and at that point monetary base and short-term debt will no longer be the same thing. Indeed. But at that point the Fed will be seeking to reduce the monetary base — by definition: it’s only once the Fed is trying to curb the size of the base that the zero lower bound ceases to be binding.
Buying treasuries with newly printed money when rates are at zero percent is an asset swap, nothing more.
Here’s the interesting bit. Krugman says that the result of this equivalence between short-rates and cash means that the Fed’s QE is really just a duration change by the Treasury. In quantitative easing, as contemplated in this next round, the Fed will be buying long-dated Treasuries. Given the preceding analysis, it’s as if the Treasury started issuing a huge slug of short-term debt and retired a bunch of long-term debt, making short-duration bills relatively more plentiful than ten-year or five-year Treasury bonds. I really didn’t think about it this way until I put the Hussman piece together with my November article. But Krugman’s characterization of this is true.
So, this gets us back to the question of what this – altering the term structure of Treasury debt – would actually accomplish in a liquidity trap. Here, commentary by Hussman is useful.
One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data, and you will find no evidence of it. Over the years, I’ve repeatedly emphasized that inflation is primarily a reflection of fiscal policy – specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970′s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you’ll find massive increases in government spending that were made without regard to productivity (Germany’s hyperinflation, for instance, was provoked by continuous wage payments to striking workers).
Likewise, real economic growth has no observable correlation with growth in the monetary base (the correlation is actually slightly negative but insignificant). Rather, economic growth is the result of hundreds of millions of individual decision-makers, each acting in their best interests to shift their consumption plans, saving, and investment in response to desirable opportunities that they face. Their behavior cannot simply be induced by changes in the money supply or in interest rates, absent those desirable opportunities.
You can see why monetary base manipulations have so little effect on GDP by examining U.S. data since 1947. Expand the quantity of base money, and it turns out that velocity falls in nearly direct proportion. The cluster of points at the bottom right reflect the most recent data.
Expanding the money supply doesn’t do anything. That is the clear upshot of what Hussman says. QE won’t work to expand the economy except to the degree the term structure of treasuries drives down rates. But of course, you have to weigh this against the lost interest income that this entails.
Bottom line: QE will be a bust; The US is in a liquidity trap. The only way out is through fiscal policy or a liquidation of excess capacity. I prefer the latter as the primary goal because it is geared to the longer term. Given the hugely misallocated US economy and the excess capacity, fiscal policy is likely to only be effective in the short-run.
Source: Bernanke Leaps into a Liquidity Trap, John Hussman