Sounds like drowning in a sea of money right? You’re not that far off. Unfortunately, a liquidity trap isn’t as great as being covered in cash. It’s about as great as having so much cash you choke on it and die. Emphasis on the death. Hopefully you’re familiar by now with John Maynard Keynes, the economist that had the impact on economics the same way Freud did on psychiatry. Only Keynes’ theories are still applied today and as far as I know, he wasn’t a cracked out perv. For a quick review of Keynesian economics: when the economy is in a recession the government should step in and stimulate the economy, running up a deficit if need be.

Government spending to stimulate the economy is known as fiscal policy. The stuff the Federal Reserve does during a recession is known as monetary policy. Basically the Fed tries to lower interest rates so that the cost of borrowing is low enough that we all borrow and stimulate the economy again. Keynes believed that the only thing monetary policy can do is impact interest rates, and that the potential exists for a situation where no matter how low interest rates are, no one wants to borrow. Keynes’ version is slightly more complicated, but this is sufficient for this post.

So what is a liquidity trap then? Imagine a situation where interest rates are practically zero and yet no one wants to borrow money. Can’t imagine it? Are you sure???? Think real hard! If you need a hint: The Fed meets today and tomorrow to discuss the setting of their target interest rate AKA the federal funds rate. Since the end of 2008, their target rate has been 0-0.25%. That’s 0.25% at the maximum! You can’t get closer to zero than that. They’ll announce on Wednesday whether or not they’ll change this. Though an interest rate change will happen sometime, I’d be surprised if it changed in this next meeting.

Of course a 0% interest rate from The Fed doesn’t mean it costs you nothing to borrow money. Banks have to charge a higher rate to cover there costs plus some profit. For example, 30 year mortgage rates have been hanging out around 5.15% lately. Rates have been this cheap for a while now and yet we’re still experiencing a slow recovery. Why is that? It’s the liquidity trap. We have have an economy flush with cash, but no one wants to lend it and no one wants to spend it. Keynes would say that The Fed can’t control the economy with monetary policy anymore. And he’s probably right.

So why does no one want to lend or borrow? Uncertainty. You don’t want to borrow to buy a home because you’re scared values will continue to fall. Banks don’t want to lend because they’re worried you’ll lose your job. We’ve got all the money in the world and no one wants to spend it.

This is a generalization of course and perhaps this post would have been more appropriate a year ago when we were still struggling. I don’t have a lesson or anything to teach you from this, I just love the words “Liquidity Trap” and thought the idea was very interesting.

Photo: Pictures from Heather

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categories: economics, government