What is the liquidity trap?
A liquidity trap is a situation in which interest rates are low and savings rates are high, which makes monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the widespread belief that interest rates will soon rise (which would lower bond prices). Since bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset whose price is expected to fall.
The Reserve Bank and a liquidity trap
In a liquidity trap, if the reserve bank of a country, like the Federal Reserve of the United States, tried to stimulate the economy by increasing the money supply, that would have no effect on interest rates, because people don’t need to be encouraged to hold additional funds. cash.
As part of the liquidity trap, consumers continue to hold funds in standard deposit accounts, such as savings and chequing accounts, rather than other investment options, even when the banking system central is trying to stimulate the economy by injecting additional funds. The high level of consumer savings, often stimulated by the belief of a negative economic event on the horizon, makes monetary policy generally ineffective.
Belief in a future negative event is essential, because when consumers accumulate money and sell bonds, it will lower the price of bonds and increase yields. Despite rising yields, consumers are not interested in buying bonds because bond prices are falling. Rather, they prefer to hold cash at a lower return.
Signs of the liquidity trap
One of the markers of a liquidity trap is low interest rates. Low interest rates can affect the behavior of bondholders, as well as other concerns about the nation’s current financial situation, resulting in the sale of bonds in a way that hurts the economy. In addition, additions to the money supply do not result in price level changes, as consumer behavior tilts towards a low-risk fund economy. Since an increase in the money supply means that there is more money in the economy, it is reasonable that some of this money should be allocated to high-yielding assets such as bonds. But in a liquidity trap, this is not the case, it is simply hidden in the cash accounts as savings.
Low interest rates alone do not define a liquidity trap. For the situation to be eligible, there must be a shortage of bondholders wishing to keep their bonds and a limited supply of investors seeking to buy them. Instead, investors favor strict cash savings over the purchase of bonds. If investors are still interested in holding or buying bonds at times when interest rates are low, even close to zero percent, the situation cannot be viewed as a liquidity trap.
Lenders and borrowers
A notable problem with a liquidity trap concerns financial institutions that have trouble finding qualified borrowers. This is compounded by the fact that, with interest rates close to zero, there is little room for additional incentives to attract well-qualified candidates. This lack of borrowers often manifests itself in other areas as well, where consumers typically borrow money, such as buying cars or houses.
Healing the liquidity trap
There are many ways to help the economy get out of a liquidity trap. None of this can work on its own, but can help encourage consumers to start spending / investing again instead of saving.
- The Federal Reserve can raise interest rates, which can encourage people to invest more of their money, rather than hoarding it. It may not work, but it is a possible solution.
- A (big) drop in prices. When this happens, people simply cannot help but spend money. The lure of falling prices becomes too attractive, and savings are used to take advantage of these low prices.
- Increase public spending. When the government does so, it implies that it is committed and confident in the national economy. This tactic is also fueling employment growth.
Key points to remember
- A liquidity trap arises when monetary policy becomes ineffective due to very low interest rates and consumers prefer to save rather than invest in high yield bonds / investments.
- If a liquidity trap is a function of economic conditions, it is also psychological, because consumers choose to hoard instead of choosing more profitable investments because of a negative economic vision.
- A liquidity trap is not limited to bonds. It also affects other sectors of the economy as consumers spend less on products, which means that companies are less likely to hire.
- Some ways out of a liquidity trap include raising interest rates, hoping that the situation will settle down as prices fall to attractive levels or higher public spending.
Real example of the liquidity trap in Japan
From the 1990s, Japan was faced with a liquidity trap. Interest rates continued to fall, yet there was little incentive to buy investments. Japan faced deflation in the 1990s and, in 2019, its interest rate is still -0.1%. The Nikkei 225, the main stock market index in Japan, rose from a peak of 39,260 in early 1990 and, like 2019, remains well below that peak. The index hit a multi-year high of 24,448 in 2020.
Governments sometimes buy or sell bonds to help control interest rates, but buying bonds in such a negative environment does little, because consumers are keen to sell what they have when they can. . As a result, it becomes difficult to drive up or down yields, and even more difficult to entice consumers to take advantage of the new rate.
As noted above, when consumers are afraid of past or future events, it is difficult to encourage them to spend, not to save. Government actions become less effective than when consumers are more concerned with risk and return than when the economy is healthy.