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What Is the Liquidity Trap?

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Publié le 28 août 2017
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Some economists such as a Nobel Laureate Paul Krugman are of the view that if the US were to fall into liquidity trap the US central bank should aggressively pump money and aggressively lower interest rates in order to lift the rate of inflation. This Krugman holds will pull the economy from the liquidity trap and will set the platform for an economic prosperity. In his New York Times article of January 11, 2012, he wrote,

If nothing else, we've learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it's a very real threat, and if and when it ends we should nonetheless be guarding against its return — which means that there's a very strong case both for a higher inflation target, and for aggressive policy ...(of the central bank).

But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?

The Origin of the Liquidity-Trap Concept

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity 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 expenditure 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. Therefore, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

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, etc.

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 re-establishing the circular flow of money, so it is held.

In his writings, 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 would not fall further.

This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people's demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries 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 can be on all sorts of projects — what matters here is that a lot of money must be pumped, which is expected to boost consumers' confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby re-establishing the circular flow of money.

Do Individuals Save Money?

In the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this is seen as saving less.

Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed as saving 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 from too much saving and the lack of spending, so it is held.)

However, to suggest that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.

Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some point in the future).

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, that is, it cannot alter so-called 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, a liquidity trap does not emerge in response to consumers' massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.

The Liquidity Trap and the Shrinking Pool of Real Savings

According to Mises,

"The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way."2

As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and non-productive 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 the amount it releases. This 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.)

Once the economy falls into a recession because of a falling pool of real saving, any government or central bank attempts to revive the economy must fail.

Not only will these attempts not revive the economy; they will deplete the pool of real savings further, thereby prolonging the economic slump.

Likewise, any policy that forces banks to expand lending "out of thin air" will further damage the pool and will reduce further banks' ability to lend.

Note that the essence of lending is real savings and not money as such. Real savings impose restrictions on banks' ability to lend. (Money is just the medium of exchange, which facilitates real savings.)

Also, note that without an expanding pool of real savings any expansion of bank lending is going to lift banks' nonperforming assets.

Contrary to Krugman, we suggest that if the US economy were to fall into a liquidity trap the reason for that is not a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings.

What is required in this case is not to generate more inflation but the exact opposite. Setting a higher inflation target, as suggested by Krugman, will only weaken the pool of real savings further and will guarantee that the economy will stay in a depressed state for a prolonged time.

  • 1. John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan &
    Co. Ltd. (1964), p. 207.
  • 2. Ludwig Von Mises, Human Action, Contemporary Books, p.490.
Source : mises.org
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1116 words. Reading time 10 minutes, because you'll laugh, you'll cry, you fall off your chair.

Here are my two cents worth about money, employment and interest rates. I have no
economic theory or solution to propose, I am just speaking from experience.

1) A government that encourages shipping productive jobs overseas, because the
managers, owners and shareholders of large manufacturing concerns can make
more profit by producing at a lower cost, even while prices don’t go up that much,
is by and large a capitalist government.
The people in charge play what I call “Jobs Jenga”, where the one who removes the most jobs without collapsing the economy wins, for the time being.

If I believe that this can work in the short run, I am Capitalist Tool. Plus, if I believe that this will work in the long run, I am a Capitalist Fool. There I go again. My My!

Consequence #1: This alone will reduce the purchasing power of the population, especially those who are unemployed.

2) A government that keeps interest rates very low accomplishes two things:

a) The government itself can borrow much more at much cheaper rates, if it controls
the market. So it will definitely borrow more than it reasonably should, because there
are either no limits, or there are only those limits it itself controls and overrules.

b) Retired people, and those who skimped and saved to accumulate, say, $200,000 in order to live off it, or rather just subsidize their meager Soc Sec benefits, will find that
in a super low interest rate environment (such as long term certificate of deposit rates of 1.25%) their annual earnings on savings of $200,000 are about $2,500, in 2017 dollars. For these people, low interest rates are similar to a “swarm of locusts that eats 80% of their crop value”, or may be akin to “an invading army that literally salts your fields so that your crop yield will drop below subsistence values, as if they wanted to make you starve”.

So, now, your savings are no longer worth as much as you thought they’d be,
because a thing is worth both “what it is” and “what it brings (the interest)”. If it doesn’t bring anything, then it’s only “What it is”.

I give you simple grade school math, and I know your hate math:

It was not too long ago that you could reliably make 6% in CD’s. That $200,000 in savings would have yielded $12,000 per year at 6%. If Soc Sec paid you $800 per month, with an extra $12,000 per year, or $1,000 per month, you would have been
able to make it in retirement with $1,800 per month, in the low rent district. With lower
than normal interest rates, you can’t make it. You are forced to live off the principal,
and at a rate of 1.25%, and using $12,000, you have used up your principal in 18 years. If there is any serious inflation in those 18 years, you’ll be done with your
money much sooner, I can tell you that, nay, guarantee you that.

Consequence #2: This in addition will reduce the purchasing power of the population, especially those who are retired and unemployed and unable to work.


Meanwhile, Social Security won’t be able to pay your full expected monthly check by about 2032. About 20 years ago, I faintly remember that this date was supposed to be around the year 2048 or so.

So let’s do a simple extrapolation: (Extrapolation is a fancy term for the type of guesswork best expressed in song lyrics: By the time I get to Phoenix, you’ll probably be in Albuquerque, or something like that …)

So: If in the last 20 years the point of “not getting your fair share from Soc Sec” has come 16 years closer (2048-2032), then in the next 10 years, that point will easily come closer by another 8 years. (Assuming that congress does nothing, which I have sort of come to expect, except for changes to the worse...)

So, then, thus and therefore, 2032 less 8 years is 2024. And 2017 plus 10 is 2027.
Hence and consequently, sometime between 2027 and 2024 your Soc Sec benefits will likely start shrinking, in actual dollar terms, without even considering inflation .
“10 years from now” is too close for comfort, because 2007 seems like it was just three years ago from 2017. This makes more sense the older you get.
(My math teacher always told me to be more exact, but off the top of my in-exact head, this is the best I can do.)

The above is for people who actually were able to save up $200,000. The great majority of us have less, much less than $20,000. Many not even $2,000 in total.

What will we do then? Rob a bank of worthless money, so you can get your three square meals and a cot for free?

3) Meanwhile though, the various banks and finance companies have managed
to convince congress that “previously called usurious interest rates, that is, rates
greater than 8% per year” should be made lawful and proper, and apparently a sufficient amount of cash was thrown into election and re-election coffers to make
that argument stick.

So, while you get only 1.25%, if you need to borrow money, it’s going to cost you
anywhere from 8% to 29.98%. Or even more. Except for gov’t supported mortgage
loans, and car-industry supported car loans, where different rules apply.

Consequence #3: This in addition will reduce the purchasing power of the population, especially those who are in debt, who pay much of their earnings in interest.

The recipients of this interest may or may not spend more, because they already seem to have so much, that they don’t know what to spend anything on. The super-rich might also be concerned that they don’t have enough money, so they might not spend it. May be some luxury goods will have a good market, but not the rest of us.

In economics I was told that “Savings equals Investment”. I am no longer sure of that, because the more worthless your money becomes, the more of it do you need to have and hold to feel “reasonably comfortable”, and the richer you are, the more this applies.

How far away have we come from the 3 - 5 - 3 rule of banking of the 1950’s.
It meant “Pay 3% to the depositor, lend it out at 5%, play golf at 3pm”. The days
of “I love Lucy”.

Of course, all these numbers will be different in dog years, and even more so, if you
are talking cat minutes.





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Your obsession with 'interest' (something for nothing) proves you know nothing about money - 'money is gold, and nothing else' J. P. Morgan, 1912.
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Your obsession with 'interest' (something for nothing) proves you know nothing about money - 'money is gold, and nothing else' J. P. Morgan, 1912. Lire la suite
kevthorne - 02/09/2017 à 06:20 GMT
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