Article / 11 February 2016 at 11:00 GMT

Can we escape a liquidity trap?

Managing Partner / Spotlight Group
United Kingdom
  • Low interest rates are generating a significant boost to aggregate demand 
  • Pointless targets are not going to create inflationary expectations 
  • Shock the market by making all past and future monetary expansion permanent 
  • Match this with a bonfire of all redundant red tape and regulation 

Looks inviting, right? But in the financial-sector – or "bad" – kind of liquidity trap, 
central bank policy loses all power to shift economic fundamentals. Photo: iStock

By Stephen Pope

In a modern free market-based economy, money is a so called “normal” good in that if the price of having it falls, then individuals and corporations would generally like more of it.

The cost of money in terms of wages for labour is the number of hours a worker has to give for those wages to be paid. If one considers borrowing, then the cost of money is the rate of interest that will have to be paid so as to service the loan.

IS-LM economic models

The economist Sir John Richard Hicks (I will call him John Hicks) was highly influential in the field of economics during the 20th century. The best known of his contributions to the science was his statement of consumer demand theory in micro, and the IS-LM model of 1937 that summarised a Keynesian view of macroeconomics.

The IS-LM model (later refined by Keynes' biographer, A.H. Hansen) is a macroeconomic tool that illustrates the relationship between interest rates and real output in the goods and services market and the money or assets market.

The intersection of the "investment-saving" (IS) and "liquidity preference-money supply" (LM) curves is the "general equilibrium" where there is simultaneous equilibrium in both markets at Y* and i*. 

Chart one: the IS-LM model

IS-LM Source: John Hicks, 1937

Liquidity trap

John Maynard Keynes introduced the concept of a liquidity trap as during the Great Depression in the 1930s US, Keynes found that economic stimulators did not have the necessary effects.

A liquidity trap is a situation characterised by low or zero interest rates which fail to stimulate consumer spending and corporate investment. Individuals and corporations are willing to hold unlimited real money balances at the given interest rate.

Perhaps the pivotal proposition in this analysis lies with expectations. These will have a major role in determining speculative balances as expectations on interest rates and their trend paths are formed by making comparisons between the existing interest rate relative to normal rates. 

For example, in the UK there was an increase in precautionary savings and a fall in spending when interest rates were cut to 0.5% in 2009.

As rates tend toward zero the implication is that the nominal interest rate cannot fall below zero or cash would be preferred to bonds and lenders would never lend at a negative interest rate to any counter party other than a secure sovereign or central bank, and so it becomes difficult for consumers and businesses to borrow.

As seen in the free market economies, there is currently either low inflation or even deflation leading to deflationary expectations even if nominal interest rates are close to or set at zero. Even if real interest rates are positive, they may be perceived as too high to stimulate the economy effectively.

The Fisher Equation, which states that the real interest rate is equal to the nominal interest rate minus expected inflation, will need to be low to stimulate consumption and investment and thus aggregate demand.

However, if nominal interest rates are low and accompanied by low inflation then there is not much the authorities can do to stimulate the economy using interest rates and thus monetary policy risks becoming ineffective.

The chart below shows the liquidity preference as Keynes argued that a fall in nominal interest rates increases the demand for money, but this does not occur in a liquidity trap as money demand has become flat.

Chart two: Interest rates and money demand
Interest rate and money demand
Source: Spotlight Ideas

When the interest rate is near zero, the demand for money becomes more or less infinitely interest-elastic. This would be shown by a horizontal LM curve; if the IS curve intersects the LM curve at a level that is less than the potential full employment level of output, then investment is zero because the interest rate is zero or in the case of the real interest rate, sub-zero.  

Chart three: Nominal, real interest rates and inflation
Nominal, real interest rates and inflation
Source: Spotlight Ideas, central banks

In the chart above I have taken the free market economies that have low or even negative nominal interest rates, or NIR. The middle section of the chart shows the inflation rate, e.g. minus 1.3% in Switzerland and then finally the real interest rate, or RIR. Of the 10 nations/regions selected, seven have negative real interest rates.

Further increases in the money supply by more quantitative easing will stretch the LM curve to the right with no effect on interest rates and output. This means consumers and corporations become indifferent to holding money and financial assets (typically fixed income bonds); there is no opportunity cost of holding money so open market operations have little effect on prices.

When prices fall in a liquidity trap environment consumers and businesses may hold more money balances because they are expecting prices to be even cheaper tomorrow, so investment and consumption are minimal; hence there is little effect on the level of aggregate demand. 

That implies that at a certain point the aggregate demand curve does not show more demand as the price level falls. It becomes kinked in a vertical direction.

How can governments and central banks engineer an escape?

One potential solution to escaping the clutches of a liquidity trap can be found if the central bank can shift private sector expectations as to the path of future inflation. If this could be done, say by forward guidance, then a lower real interest rate would generate the required stimulus to the economy.

However, as we have seen with the attempts at forward guidance from the Bank of England this is a complex thing to achive. Likewise, the stubborn adherence to the internal inflationary forecast by the European Central Bank has eroded much of the institutions credibility.

That should send a red light flashing in the Eurozone as only a credible policy from a credible institution will prove capable of driving the private sector into action to generate the economic growth necessary to deliver a higher level of output and a higher level of inflation.

The leading central banks have all used positive inflation targets as a commitment to higher future inflation. This would only be credible if they could actually show ongoing incremental gains in the level of consumer or wholesale prices.

European Central Bank
"Give us another five years, maybe?" Photo: iStock 

Rather than droning on about a 2.0% target, the ECB should deny quantitative easing support for governments that drag and delay on structural reform. Just imagine the market’s reaction if the idea of French or Italian debt at plus 33 basis points and plus 127 bps were challenged. 

Quickly, spreads could escape to plus 70 bps for France and plus 200 bps for Italy. That would light a fire under the lethargic political hacks of Paris and Rome.

Also the ECB et al. could set an inflation target above 2.0% so as to compensate for the years of lowflation. Such an announcement of an upward-sloping target for the price level would be advantageous because in the long run, even if inflation is low in one year there would be a path that would see higher inflation in the following years to make up for this.

This is a time for the central banks of all free market economies to using every single tool at their disposal and to use bright minds to create new ones. I will not advocate explicit currency depreciation as this simply opens a currency war and is a pathway that will lead to trade tariffs and quotas. 

These ultimately create a decline in consumer welfare; hardly the outcome that is desired.

I would be radical on the monetary front. This may make monetary hawks faint, however, I suggest disengaging from tapering or any talk of normalising the central bank balance sheet. Let the monetary expansion be permanent. It could reduce real interest rates via enhancing expectations of future higher inflation. Depending on the response of the private sector fiscal policy may provide the required stimulus through IS movements.

I am not a fan of expansive fiscal policy, as my earlier papers have shown. What I would encourage is a bonfire of red tape and a new wave of urgent supply-side policies through regional enterprise zones where corporation tax, national insurance or tax on income from new capital investment is given a holiday of several years.

Oxford Street
In the end, real economic activity is what matters. Photo: iStock 

— Edited by Michael McKenna

Stephen Pope is managing partner at Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.
lukehlee lukehlee
@Stephen Pope Yes, I believe we can. I would suggest you see this article, published on Huffington Post yesterday: “The Current Liquidity Trap and a New Internet‐like Open Supply Chain Process Platform” I believe this will show you a powerful way out of the current liquidity trap, and accordingly, the worldwide economic recession.


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