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The latest data for lending in the eurozone, the United Kingdom,
and the United States
display a visible weakening. In the eurozone, the
yearly rate of growth of bank lending to the private sector fell to 0.6% this
July from 9.3% in July last year. In the United Kingdom, the yearly rate
of growth of lending to the private sector fell to 2.2% in July 2009 from
10.1% in July 2008. In
the United States,
the rate of growth of lending plunged to minus 3.8% in August 2009 from a
positive figure of 8.6% in August 2008.
 
A weakening in the growth momentum of lending has taken place despite
central banks' massive monetary pumping. Commercial banks in major economies
are finding it more attractive to sit on the newly injected money rather than
lend it out.
At the end of July this year, US banks were sitting on $729 billion of
cash against $1.9 billion in July last year.
In the United
Kingdom, bank cash reserves jumped from
£28.6 billion in July last year to £161.3 billion at the end of
July this year.
In the eurozone, bank reserves climbed to
€505 billion in June this year from €227 billion in June last
year before settling at €394 billion in July this year.
Some commentators are of the view that banks' preference to sit on a
growing pile of cash rather than lend it out points to an emerging liquidity
trap, which can pose a serious threat to economic growth.
The Origin of the Liquidity-Trap Concept
In the popular framework of thinking, which originates in the writings
of John Maynard Keynes, economic activity is presented in terms of a circular
flow of money. Spending by one individual becomes part of the earnings of
another individual, and spending by another individual becomes part of the
first individual's earnings.
Recessions, according to Keynes, are a response to the fact that
consumers — for some psychological reasons — have decided to cut
down on their expenditures and raise their savings.
For instance, if for some reason people have become less confident
about the future, they will cut back on their outlays and hoard more money.
So, once an individual spends less, this worsens the situation of some other
individual, who in turn also cuts his spending.
Consequently, a vicious circle sets in: the decline in people's
confidence causes them to spend less and to hoard more money, and this lowers
economic activity further, thereby causing people to hoard more.
Following this logic, in order to prevent a recession from getting out
of hand, the central bank must lift the money supply and aggressively lower
interest rates. Once consumers have more money in their pockets, their
confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money, so it is held.
However, Keynes suggested that a situation could emerge when an
aggressive lowering of interest rates by the central bank would bring rates
to a level from which they could not fall further.
This, according to Keynes, could occur because people might adopt the
view that interest rates have bottomed out and that rates will subsequently
rise, leading to capital losses on bond holdings. As a result, peoples'
demand for money would become extremely high, implying that they would hoard
money and refuse to spend it no matter how much the central bank tried to
expand the money supply.
Keynes wrote,
There is the possibility, for the reasons discussed above, that, after
the rate of interest has fallen to a certain level, liquidity-preference
may become virtually absolute in the sense that almost everyone prefers cash
to holding a debt which yields so low a rate of interest. In this event the
monetary authority would have lost effective control over the rate of
interest.[1]
Keynes suggested that, once a low-interest-rate policy becomes
ineffective, authorities should step in and spend. The spending could be on
all sorts of projects — what matters here is that a lot of money must
be pumped in order to boost consumers' confidence. With a higher level of
confidence, consumers would lower their savings and raise their expenditures,
thereby reestablishing the circular flow of money.
Observe that Keynesian ideas have been promptly implemented by the
governments and central banks of the major economies. Yet despite all the
stimulus packages and the massive money pumping, lending remains depressed.
Bank lending is an important factor in making the central bank's
pumping "effective." Popular thinking holds that lending enables
the reestablishment of the circular flow of money and eliminates the
liquidity trap.
To push major economies away from this trap, some experts suggest that
major central banks should consider the recent policy move of the central
bank of Sweden.
In July this year, the Swedish Riksbank
became the world's first central bank to introduce negative interest rates on
bank deposits held with the central bank, lowering the deposit rate to minus
0.25% from 0% in June. Note that in July last year, the rate stood at 3.75%.
The idea of negative interest rates is to make it costly for banks to
sit on cash reserves. It is held that banks will be forced to expand their
lending, thus helping to reestablish the circular
flow of money.
Do Individuals Save Money?
In the Keynesian framework, the key to prosperity is the
ever-expanding monetary flow. Monetary expenditure drives economic growth.
When people spend more of their money, they save less. Conversely,
when people reduce their monetary spending in the Keynesian framework, they
save more.
Observe that in the popular, i.e., Keynesian, way of thinking, savings
is bad news for the economy. The more people save, the worse things become:
the liquidity trap comes on account of too much saving and the lack of
spending.
Now, contrary to popular thinking, individuals don't save money as
such. The chief role of money is that of the medium of exchange. Also, note
that people don't pay with money but with goods and services they have
produced.
For instance, a baker pays for shoes by means of the bread he
produced, while the shoemaker pays for the bread by means of the shoes he
made. When the baker exchanges his money for shoes, he has already paid for the
shoes, so to speak, with the bread that he produced prior to this exchange.
Again, money is just employed to exchange goods and services.
To suggest then that people could have an unlimited demand for money,
which leads to a liquidity trap, implies that no one would be exchanging
goods. Obviously, this is not a realistic proposition, given that people
require goods to support their lives and well-beings. (Note that people
demand money not to hold it as such but to employ it in exchange.)
Being the medium of exchange, money can only assist in exchanging the
goods of one producer for the goods of another producer. The state of the
demand for money cannot alter the amount of goods produced, i.e., it cannot
alter real economic growth. Likewise, a change in the supply of money doesn't
have any power to grow the real economy.
Contrary to popular thinking, we suggest that a liquidity trap doesn't
emerge in response to consumers' massive increase in the demand for money but
comes as a result of very loose monetary policies that inflict severe damage
on the pool of real savings.
The Liquidity Trap and the Shrinking Pool of Real Savings
The essence of lending is real savings and not money as such. It is
real savings that imposes restrictions on banks' ability to lend. Money is
just the medium of exchange, which facilitates real savings.
As long as the rate of growth of the pool of real savings stays
positive, this can continue to sustain productive and nonproductive
activities. Trouble erupts, however, when, on account of loose monetary and
fiscal policies, a structure of production emerges that
ties up much more consumer goods than it releases. The excessive
consumption relative to the production of consumer goods leads to a decline
in the pool of real savings.
This in turn weakens the support for economic activities, resulting in
the economy plunging into a slump. (The shrinking pool of real savings
exposes the commonly accepted fallacy that the loose monetary policy of the
central bank can grow the economy.)
Needless to say, once the economy falls into a recession on account of
a falling pool of real savings, any government or central bank attempts to
revive the economy must fail. Not only will these attempts fail to revive the
economy, but they will deplete the pool of real savings, thereby prolonging
the economic slump.
Likewise, any policy that will force banks to expand lending out of
"thin air" will further damage the pool and further reduce banks'
ability to lend. Note that without an expanding pool of real savings, any
expansion of bank lending is going to lift banks' nonperforming assets.
The fact that banks are not currently ready to expand lending
indicates that they are still in the process of trying to fix their balance
sheets. Also, banks cannot find many viable borrowers, i.e., wealth
generators, which could be another indication that the pool of real savings
is in trouble.
Meanwhile, the Federal Deposit Insurance Corporation (FDIC) data show
that US
commercial banks' and savings institutions' assets remain under pressure. The
value of assets fell by $241 billion in the second quarter (Q2) after
declining by $301 billion in the previous quarter (Q1). The growth momentum
of assets also displayed a visible fall. The yearly rate of growth fell to
nil in Q2 from 1.3% in Q1 and 11.6% in Q1, 2008.
In Q2, commercial banks and savings institutions have reported renewed
pressure on their net income. The banking industry recorded a loss of $3.7
billion after having a profit of $5.5 billion in Q1. Provisions for bad loans
have bounced to $66.9 billion in Q2 from $61.4 billion in Q1.
We can thus conclude that, contrary to popular thinking, the threat to
major world economies is not the so-called liquidity trap, but the government
and central bank stimulus policies claimed to counter it. These policies only
further weaken the pool of real savings, thereby undermining prospects for a
durable economic recovery and perpetuating the liquidity trap.
Conclusions
So far, massive monetary pumping by central banks has failed to revive
the pace of credit expansion in major world economies. Some commentators have
raised the possibility that this points to an emerging "liquidity trap," which is seen as a major threat to economic
growth.
To push economies away from this trap, some experts suggest that major
central banks should consider the recent policy move of the central bank of Sweden. The
Swedish central bank has introduced negative interest rates on bank deposits
held with the central bank. It is believed that negative interest rates will
force banks to start expanding lending. This, it is held, is going to revive
economic activity in a sustained way.
We suggest that negative interest rates are unlikely to move major
economies away from a liquidity trap if the pool of real savings is in
trouble. Contrary to popular thinking, the threat posed to the major
economies is not the liquidity trap, but the government and central bank
stimulus policies aimed at countering it.
Frank Shostak
Frank Shostak is a former professor of economics and M. F. Global's chief economist.
Also
by Frank Shostak
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