What Is The Liquidity Trap?

Authored by Frank Shostak via The Mises Institute,

Some economists such as a Nobel Laureate Paul Krugman are of the view that if the US were to fall into a liquidity trap the US central bank should aggressively pump money and aggressively lower interest rates in order to lift the rate of inflation. This Krugman holds will pull the economy from the liquidity trap and will set the platform for an economic prosperity. In his New York Times article of January 11, 2012, he wrote,

If nothing else, we've learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it's a very real threat, and if and when it ends we should nonetheless be guarding against its return — which means that there's a very strong case both for a higher inflation target, and for aggressive policy ...(of the central bank).

But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?

The Origin of the Liquidity-Trap Concept

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual's earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. Therefore, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

A vicious circle sets in: the decline in people's confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates.

Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money, so it is held.

In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further.

This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people's demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply.

Keynes wrote,

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects - what matters here is that a lot of money must be pumped, which is expected to boost consumers' confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby re-establishing the circular flow of money.

Do Individuals Save Money?

In the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this is seen as saving less.

Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed as saving more.

Observe that in the popular — i.e., Keynesian — way of thinking, savings is bad news for the economy: the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)

However, to suggest that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.

Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some point in the future).

Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer.

The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter so-called real economic growth.

Likewise, a change in the supply of money doesn't have any power to grow the real economy.

Contrary to popular thinking, a liquidity trap does not emerge in response to consumers' massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.

The Liquidity Trap and the Shrinking Pool of Real Savings

According to Mises,

"The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way."

As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and non-productive activities. Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than the amount it releases. This excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings.

This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real savings exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.)

Once the economy falls into a recession because of a falling pool of real saving, any government or central bank attempts to revive the economy must fail.

Not only will these attempts not revive the economy; they will deplete the pool of real savings further, thereby prolonging the economic slump.

Likewise, any policy that forces banks to expand lending "out of thin air" will further damage the pool and will reduce further banks' ability to lend.

Note that the essence of lending is real savings and not money as such. Real savings impose restrictions on banks' ability to lend. (Money is just the medium of exchange, which facilitates real savings.)

Also, note that without an expanding pool of real savings any expansion of bank lending is going to lift banks' nonperforming assets.

Contrary to Krugman, we suggest that if the US economy were to fall into a liquidity trap the reason for that is not a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings.

What is required in this case is not to generate more inflation but the exact opposite. Setting a higher inflation target, as suggested by Krugman, will only weaken the pool of real savings further and will guarantee that the economy will stay in a depressed state for a prolonged time.


Drop-Hammer Aug 29, 2017 9:25 PM Permalink

It is not a liquidity trap, it is a jew trap.  All of this is jew-spew intended to benefit the Christ-killers to da goyim's detriment.  We just need rid ourselves of the jews and thus, the jew trap.

Haitian Snackout Aug 28, 2017 9:37 PM Permalink

This is nonsense. What is the savings rate about 5% + or -?  Wake me up when it gets to 20%. And yes, I understand most people save nothing so the averages mask the effects of the ZH group.

conraddobler Aug 28, 2017 9:28 PM Permalink

What is going on is that to maintain margins as the illusion is cratered, prices have to keep rising even against falling demand.If you had ever listened to stories of the last great depression this is all entirely consistent with what my Grandfather always said.He said that there was no end of stuff to buy but no one could afford anything.It was not a case where stuff was not available to buy, even if people could afford it they had no idea if they could afford it tomorrow or even if they could afford to eat.The only difference between the two era's is that now people have easy access to credit and government transfer payments but a curious thing is going on.The tax on being good at anything is at an all time high.Eventually this will consume any and all legit producers of value and transfer it to the tit sucking class.At which point the entirety of the illusion will go POOF.Then they roll the tanks, and go full Soviet on everyone.So simple a dying Republic could do it.

silverer Aug 28, 2017 9:11 PM Permalink

OK. Let's assume people spend every nickel they ever saved. Then they go out and pump up their borrowing to the very maximum. Even lie to get an extra 10% or so. Then they run out and spend every nickel, and max out their credit cards. Will that completely fix the economy and put every thing back on track? Hmm...

mendigo Aug 28, 2017 7:09 PM Permalink

Not sure I buy it.Clearly there is a tendency to want to have more savings and less debt when there exist more risk. It is perverse for our government to coerce us to deplete savings or load up on debt.And this happens regardless of anticipated inflation/deflation. Its about the near term.

css1971 Aug 28, 2017 6:59 PM Permalink

You're talking as if you don't know banks create money. They simply write it into the  account They don't lend you other people's money at all.

striped-pad css1971 Aug 28, 2017 7:53 PM Permalink

They don't lend you other people's money at all.

That's right, – the bank becomes indebted to you, so you can buy stuff with the bank's own net worth instead of your own. Of course, in exchange you have to write an IOU of equal value to the bank, and pay them some interest as insurance against your defaulting, because if you default the bank is still indebted to whoever has the new money.

At least, that's the way it ought to work. There's nothing inherently wrong with banks (or anyone else) creating IOUs – as long as they have enough assets to pay all their liabilities. Banks must remain solvent for everything to work.

Banks in danger of becoming insolvent must be liquidated. Banks already insolvent must be liquidated, the losses allocated fairly, and the people who allowed them to continue to write IOUs they couldn't keep should be held to account.

In reply to by css1971

SeaMonkeys Aug 28, 2017 6:39 PM Permalink

This might be relevant. Bloomberg says the economy is where it's at because of a half trillion dollar increase in consumer debt over lthis time last year, and because people are spending from their savings account, as opposed to from their income.https://www.bloomberg.com/news/articles/2017-08-16/don-t-be-shocked-if-… Ponzi scheme of how money functions in our economy relies on money solely as an investment for its issuers. This narrowly defined, would be banks. But don't forget that corporations need us to buy their shiny objects. This means that there is a collusion of sorts between banks, non-financial corporations, and government, in order to create demand. By government, I mean both Democrats and Republicans. There are no good guys who are partisan. The 2 parties are a mafia and the mafia is a criminal organization.This kind of artificial demand is, as I understand it, the opposite of real demand that Mises and the Austrians value. I am not an Austrian, but I am very sympathetic. Say's Law can't be allowed to exist in our ponzi scheme. Today's financialized consumer economy is completely artificial. Productivity is just an abstract term that economists use. It's meaningless to the rest of us. How many people find meaning in their work? Very few. Work and money are just components in a grand game that guarantees winnings for the players sitting at the table. Money is not a unit of value in the real world. This can only mean that work, in the aggregate, has no social value. Work is just a means to enrich the owners. Without Say's Law, ownership and work are only connected legally. There is no circular flow of money that represents anything of social value. It's a win-win for the big players and a lose-lose for the rest. In other words, it's socialism for the rich, capitalism for the rest of us. We little people are the only ones with actual skin in the game.

Blue Steel 309 Aug 28, 2017 6:21 PM Permalink

Is this the trap where hyperinflation is only prevented through credit created tangentially to fiat? Who believes this crap anymore?

And Chosenite Tribesmen have run the Nobel committee for a long time, so the prize doesn't deserve the prestige the propagandist media still gives it(referring to paragraph 1).

DjangoCat Aug 28, 2017 6:00 PM Permalink

Money saved in the bank, or put into new bond issues, or new equity can be viewed as positive for the economy by providing real investment in future production.  What we see now with the flight to PMs and crypto is a removal of value from the fiat system.  If it accelerates, the real money supply should decrease, but it does not, because gold and crypto are not counted in the supply figures and the fiat $s persist.  Money supply only decreases as debts are repaid or defaulted on.So, while we have a value transfer out of the fiat system, in effect we see an underground QE happening outside the control of the central bank as a devalued fiat money continues to float around.  No matter what the CBs do now, they have lost the confidence of a significant sector of society, the holders of significant savings, the retired people.  They see the dollar value declining and want out.

falak pema Aug 28, 2017 5:59 PM Permalink

this guy forgets that : GDP = C+I+G+Ex-Imp.What this article does not address is that  savings can be invested to generate innovation which creates productivity increase, lower costs and helps consumption.Both government spend and private investment can help savings being either injected via taxes or via PI to kick start the circular flow and avoid liquidity trap.The key is that savings should feed  one or the other. Buying houses or stocks/bonds are typical PI items.Why does this article not highlight  PI as other way of avoiding liquidity trap?The key is to avoid bubbles of PI based on short term investment for speculative profit only, not for producitivty gains.Keynes's model found a balance between C/G/I to avoid both bubbles and recessions.It required that ONE currency not be a hegemonic yardstick--Triffin's Paradox--which is what Friedman did to avoid USD decline under imports and govt. overspend, by getting off the gold exchange and then going to "print print print" $ as hegemonic monetary god.Von Mises as usual avoids that pitfall by blaming Keynes and not addressing Friedman's false mantra. Keynes was dead and long gone in 1971. The current problem is of Friedman's and Reaganomics' making, as govt. spend and financial speculation combined to  kill the cat.We killed taxing the rich to feed productivity or to feed consumption and it went into the Casino.

CNONC falak pema Aug 28, 2017 9:20 PM Permalink

"The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way."Did you read the article?  The point he makes is that savings is the principle source of productivity increases.  Attempts by monetary authorities to incentivize consumption at the expense of savings, which is the Keynesian response to recession, further reduces savings, which results in lower productivity growth.Understand the argument before posting next time. 

In reply to by falak pema

DjangoCat falak pema Aug 28, 2017 6:37 PM Permalink

As one does, I was reading somewhere recently that the private and public investment decisions are based upon an analysis of likely returns.  Some time ago, I read that the IMF was having trouble finding projects that would return at least 10%.  In the private domain, the same problem holds.  Most investments do not hold any hope of decent returns.As a result, equity has to be leveraged with large quantities of very cheap debt in order to come up to the desired return levels.This is the trap.  If equity can not make a sufficient return by itself, all investment requires that interest rates need to be kept very low. There is little to no expectation that the debt can be repaid, vis the US fracking industry.  They require cheap debt in order to keep drilling, in order to produce enough oil to pay the ever increasing interest cost.  Forget about repayment.  Not happening.  So we see ever increasing debt to keep the oil flowing.As a secondary consideration, the investment return on energy extraction has declined to the point where new investment is declining precipitously.   This means that future oil and gas supply is in jeopardy and that the wheels may fall off industrial society in the fairly near future.  Oil and gas still represent over 80% of global energy consumption.The western world has enjoyed 150 years of growth from the surpluses produced by cheap energy.  With depletion of this source of ever increasing wealth, we are turning to ever increasing debt to keep the wheels turning.  How long can that last?

In reply to by falak pema

DrData02 Aug 28, 2017 5:39 PM Permalink

"Please note: people demand money not to accumulate indefinitely but to employ in exchange at some point in the future."

At some point some acquire so much wealth that this is not the case.

striped-pad DrData02 Aug 28, 2017 7:37 PM Permalink

Do they accumulate so much money though? That's Keynes's argument - not that they accumulate wealth. His argument immediately falls down if it's just wealth accumulation.

Even if they do accumulate money (and I'd want to see some evidence of that), but don't intend ever to spend it, they're effectively just writing off the debt of whichever bank owes it to them.

In any case, whatever happens with saving, even if there are trillions of dollars of FRNs hidden under the mattresses in Chateau Rothschild, it's always possible for other people to create more valuable money. Anyone who has a positive net worth can use it as collateral for a secured loan, which creates new money fully backed by the value of the collateral.

In reply to by DrData02

HRH Feant2 (not verified) Aug 28, 2017 5:32 PM Permalink

"Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed as saving more.

Observe that in the popular — i.e., Keynesian — way of thinking, savings is bad news for the economy: the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)"

If this is their best thinking we are fucked. People in the US are not saving. That is the problem! How can living paycheck-to-paycheck be called a good thing? I consider that the definition of insanity.

We are fucked. God help us because the Federal Reserve is in la la land.

JRobby Aug 28, 2017 5:22 PM Permalink

But instead of honoring our elderly like they do in Japan, we euthanize ours and import millions of immigrants to pump out workers for the oligarchy.

HillaryOdor JRobby Aug 28, 2017 5:27 PM Permalink

If I were elderly I would think it the highest form of dishonor to destroy the future of my nation, whether it was in the name of taking care of me or not.  If your offspring don't thrive, you immediately become irrelevant.  The current generation could learn something by thinking about the future instead of instant gratification.

In reply to by JRobby

Sonny Brakes Aug 28, 2017 5:22 PM Permalink

Some people work too hard to earn their shekels and they tend to save their money. Those same people don't have the energy to enjoy the things Mr. Big expects them to buy. Personally, I'm done with supporting this criminal enterprise we call an economy.

Blue Balls (not verified) JRobby Aug 28, 2017 6:55 PM Permalink

"We are stuck in the trap just like Japan"Only because they want to be.  Simple solution.  Raise FF rate to 3% + inflation or 2%+3% = 5%.  Liquidate malinvestment.  Wait 6-18 months while markets correct.  Normal again.  Balance the budget, raise interest rates.  Fucking simple 1921-23 solution proven to work.The Fed and other central banks do not want this because they are egaged in a Coup d'état against democratic elected governments.  A communist Venezuelan style Coup d'état where the state assumes ownership of everything through theft, inflation, and legislation.

In reply to by JRobby

Muppet JRobby Aug 28, 2017 6:49 PM Permalink

Amazon's cut in grocery costs is deflationary and significant.   Competition drives lower profit margins begets lower wages.  Lower wages beget lower tax revenues.   Debts and tax (esp. property tax) becomes unpayable.   Businesses close.   No matter how much Government prints, it all winds down. The horn bellows "Dive, Dive, Dive". Coming soon to a theatre near you. Well, back to reality, stocks continue to set all time historical records because RIGHT NOW IS THE BEST TIME EVA !!!    Longest wartime ever.  Yay.  

In reply to by JRobby

Itinerant SethPoor Aug 28, 2017 9:39 PM Permalink

When Keynes wrote about the liquidity trap and the savings paradox, he wasn't trying to describe how everything should work, but how to get out of a situation which had already occurred, obviously without Keynesian economics. In fact, the world was full of people preaching hard money and austerity back then, so obviously they are no solution, otherwise the problems wouldn't have come about in the first place.Keynes is not saying that savings are bad for the economy, he is just saying that if everybody tries it at the same time, the economy will choke and it won't work.The problem with Shostak, Mises, et al, is that they are always describing some ideal economy, which will happen all by itself if nobody interferes -- meanwhile, a few million people die off because they have no jobs, money, or food and nobody is allowed to do anything because that would be interfering in their ideal economy where everything sorts itself out, as long as the owners stay in their role of owning everything. Duh!The idea of having the government tax and invest anti-cyclically to the business cycle to dampen unwanted destructive harmonic waves is very sound (that's how twisted pair wiring works), and echoes Joseph in Egypt with the 7 fat and 7 lean years. Assigning the government to startup up the flow again when it stops is also eminently practical, since no other party can. How it is that the economy lands up in such ruts (just as many wheat fields, apple orchards, and factories, but people starving for lack of money and work because the whole flow has just stopped) is another matter altogether ... it would be best if you could forestall speculative booms, but that would require a lot of changes to the bank & money system, not to mention the structure of the whole economy.

In reply to by SethPoor

striped-pad JRobby Aug 28, 2017 7:20 PM Permalink

The stock of money is easy to expand.

The stock of net worth (real savings) is much harder to expand. (You actually have to produce something and not consume it). Very hard for a bureaucrat to do.

The article is absolutely correct. It is a decent stock of net worth which fosters confidence, not a large stock of bank notes of increasingly dubious value.

In reply to by JRobby