I never quite got the liquidity trap when I was in college. Not having grown up during a major war or an economic depression, the concept always seemed kind of abstract. I understood it a bit better when I was in graduate school, probably because by then I had greater general curiosity about economics. But even then, it was not easy to fathom without direct observation or experience.
Things change. The past 10-12 years are, arguably, Exhibit A. According to John Maynard Keynes, a liquidity trap describes a situation where people refrain from spending because they expect average prices to decline in the near- to medium-term future. Wars, depressions, or other economic “shocks” would likely produce such an expectation, but so might general pessimism about the future. It is called a trap because, try as the Federal Reserve (the Fed, our nation’s central bank) might to inject “liquidity” (for our purposes, money) into it, the economy remains “trapped” in a low-employment, low-output equilibrium. It is mostly because neither consumers nor businesses can be enticed to spend money.
Orthodox economics teaches that interest rates plummet during a liquidity trap, possibly approaching zero. Also, inflation is virtually non-existent despite active and persistent money creation by the Fed. Interest rates have indeed been at historically low levels since the time of the financial crisis of 2008-2009, with the Fed funds rate stuck at not much more than zero percent for most of the past dozen years. And while inflation remains present, the inflation rate has been relatively low for decades, never going anywhere near the rates seen in the late seventies. Until recently, the main evidence against the liquidity trap has been continued steady increase in consumer spending. Of course (and as I will remark much in future posts), the consumption has largely been sustained on the strength of mounting and unsustainable household debt, one critical ingredient in the financial crisis of a decade ago.
But the past two months ought to have erased any reasonable doubt about whether we are presently in a liquidity trap. Interest rates have been flirting with negativity despite massive liquidity infusions from the Fed, this time in the form of corporate bond purchases. The massive infusion was necessitated by an unprecedentedly abrupt economic collapse, apparently prompted by the social isolation imposed by state governments in response to the Covid-19 pandemic. And this time around, consumer spending has not kept up. While modestly up over the past two months, it had previously dropped almost 20 percent from February to April.
But the liquidity trap is typically presented as a paradox, in the sense that behavior that is virtuous at the individual level, namely saving, is catastrophic at the macro level. Because ours is a consumer driven economy, continuous spending is vital. Without it, production declines, job losses mount, and spending decreases further in a vicious downward spiral. Leaving aside debt (which anyway creates its own problems), more saving necessarily means less consumption.
All this seems quite close to describing what we are presently experiencing. People have virtually stopped going to restaurants, movie theaters, sporting events, and the like, with corresponding impacts on the labor market. The tens of millions sitting at home find their monthly expenditures dropping sharply because, well, there really isn’t much to do (so might as well save money). Of course, lack of spending continues to wreak havoc on the employment situation. The end seems nowhere in sight and predicting economic conditions even one or two years from now is likely a fool’s errand.
You’ve no doubt recently heard some say that things will now never go “back to normal.” But if not, then what looms ahead? Some believe that a crisis is an opportunity; or, as stated by economist Paul Romer back in 2004, “a crisis is a terrible thing to waste.” Quickly, go back to the italicized phrase two paragraphs above this one. One thing that the present economic paralysis could do is raise awareness that we are capable of enjoying a decent quality of life without incessant material consumption. In truth, many of us have already been doing so. Finding a way of restructuring the U.S. economy in a way that follows this insight could some day make saving truly virtuous, and consign the liquidity trap to the dustbin of history.