What is a Liquidity Trap?

A liquidity trap happens when interest rates come closer and closer to zero, and thereby changes in the money supply are very ineffective at stabilizing the economy.

If at first blush that does not make sense, another way to put it is like this.

“LM” is the money supply and liquidity preference combined in the IS-LM model. Visually, the central bank is trying to get the economy to “YF”, which means a higher overall economic output and full employment. But when a central bank increases LM with interest rates so low like this, it does not change Y. So the monetary transmission mechanisms” are essentially useless. On September 17 the interest rate for 3-month treasury bills (the most popular) fell to 0.06%, the lowest on record, and today are standing at 0.08%.

Japan: a case study
U.S. interest rates were well below 1% throughout the Great Depression, and the same was true for Japan in the 1990s, where they stood at one-tenth of 1%. Neo-Keynesian Gregory Mankiw, economist and author of the popular Macroeconomics textbook, says the crisis in both cases were traced to bad stock performances. Japanese land prices also peaked in the 1980s before crashing in the 1990s. It was a speculative development bubble, similar to the current one in the U.S. When the value of these holdings collapsed, the Japanese “saw their wealth plummet” and this “depressed consumer spending”. [found on p.324]

Next, the banks

“ran into trouble and exacerbated the slump in economic activity. Japanese banks in the 1980s had made many loans that were backed by stock or land. When the value of this collateral fell, borrowers started defaulting on their loans”.

This should sound very, very familiar to the U.S. sub prime mortgage default situation.

“… these defaults on the old loans reduced the banks’ ability to make new loans. The resulting ‘credit crunch‘ made it harder for firms to finance investment projects and, thus, depressed investment spending.”

What made the downturn worse were the low interest rates which made monetary ‘stabilization policy’ ineffective. That is to say, the liquidity trap. Both the Great Depression and 1990s Japan saw low economic activity coincide with low interest rates.

“… this fact suggests that the cause of the slump was primarily a contractionary shift in the IS curve, because of shift reduces both income and the interest rate. The obvious suspects to explain the IS shift are the crashes in stock and land prices and the problems in the banking system.”

Mankiw says the policy debates during the Great Depression and Japan during the 1990s were essentially the same: Keynesian, but he does not use this word.

“Some economists recommended that the Japanese government pass large tax cuts to encourage more consumer spending.”

It was their version of today’s Paulson Plan. These sorts of plans aim to shift out the IS curve instead of the LM curve. But during both the Depression and in Japan policymakers wanted to avoid budget deficits from cutting taxes and/or increasing spending.

“…Other economists recommended that the Bank of Japan expand the money supply more rapidly. Even if nominal interest rates could not go much lower, then perhaps more rapid money growth could raise expected inflation, lower real interest rates, and stimulate investment spending.”

Eventually the Japanese plan was a combination of shifting IS and LM together. If we measure recovery by unemployment, for example, Japan still has not recovered. Unemployment was 2.1% in 1991, 5.4% in 2002, and 4.5% by 2005. Real GDP grew by 4.3% during the Japanese “miracle” boom of 1980s, but during the 1990s it grew by 1.3%. This is very low by developed-country standards, and generally considered undesirable, even unsustainable.

Today’s Economic Portrait


“The liquidity trap” has not entered mainstream public consciousness yet. But as Paul Krugman
wrote last monday, the fact that we are dabbling in liquidity trap territory is becoming obvious.

“You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills — the two sides of the Fed’s balance sheet — become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent.”

Krugman has been saying since March of 2008 that we’re “pretty close” to a liquidity trap. This September we are sliding against a razor thin margin, and the possibility that we are already in a liquidity trap will only be known months later given time lags in economic data.

The technical definition of a recession is ‘two consecutive quarters of falling GDP’. But another, probably more apt, way to define recession is how many times the word comes up in the mainstream press. The more the word “recession” is used, the more consumer confidence drops, and the likelihood that we are actually in a recession becomes realistic. But the press have been using the word “recession” throughout the entire year it seems (just do a Google “trends” search), so I am beginning to think this is not a good barometer.

My new thought is that once people start using the phrase “liquidity trap”, it will imply that our understanding about the severity of the crisis has developed to such an extent that you can be sure we are in a real recession.