What’s a liquidity trap?
A situation where all attempts to stimulate an economy fail is normally described as a Liquidity Trap. Traditionally, stimulus involves lowering interest rates and increasing money supply. Basically, a Liquidity Trap is where a government pumps money into an economy but the people/organizations with spendable assets resist the temptation to spend/invest those assets. If the news is full of adverse events, civil unrest, natural disasters or predictions of falling demand, it’s easy to keep your money in your pocket. A more technical explanation would define a Liquidity Trap as a period where continued injections of liquidity into the economy have no effect on demand or interest rates, a.k.a. Infinite Elasticity of Money Supply.
OK, we are not here for Economics 101, so let’s move on to the important stuff…
Why is a Liquidity Trap Important?
If we are in a Liquidity Trap, the current U.S. macro-economic policy of Quantitative Easing (Q.E.) will have no further effect on real economic growth. We can continue to increase the national debt and deficit for no reason. Think of money supply as a rubber band. As the band (money supply) is expanded by pulling on the right hand side, demand (the left hand side) should also move at some stage. However, it remains stubbornly stationary, no matter how far money supply expands.
We call this Infinite Elasticity – the government can expand the rubber band by printing more and more money, thereby increasing its supply, with little or no net effect on the economy. A second metaphor is Q.E. is like “pushing on a string” – push as hard as you like on one end, the other end barely moves. Moreover, by “Easing” vast “Quantities” of money into our economy, the Federal Reserve thought banks would finance more loans at “too good to resist” interest rates. This would help the housing market to recover and stimulate investment, consumer and capital spending. Instead, the banks invested the money themselves, often by lending it back to the government.