With interest rates in many countries close to zero or even negative some commentators are of the view that monetary policy of the central banks are likely to become less effective in navigating the economy. In fact it is held that we have most likely have reached a situation that the economy is approaching a liquidity trap. What is this all about?

In the popular framework of thinking that originates from 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 expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back their outlays and hoard more money. Therefore, once an individual spends less, this will worsen 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 growth rate of 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. As a result, the central bank will not be able to revive the economy.

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.

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.

Does liquidity trap emerge because of lack of spending?

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 implies they save less.

Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed that they save more.

In the popular — i.e., Keynesian — way of thinking, saving 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.)

Observe however, that people do not pay with money but rather with goods that they have produced. The chief role of money is as a medium of exchange. Hence, the demand for goods is constrained by the production of goods and not by the amount of money as such. (The role of money is to facilitate the exchange of goods).

To suggest that people could have almost an unlimited demand for money that is viewed as an unlimited saving that supposedly leads to a liquidity trap would imply that no one would be exchanging goods. (It would mean that people do not exchange any longer money for 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 in order to accumulate it but to employ 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 medium of exchange service that money provides has nothing to do with the production of final consumer goods as such. This in turn means that it has nothing to do with real savings either.

What permits the increase in the pool of real savings is the increase in the capital goods. With more capital goods i.e. tools and machinery the workers ability to produce more goods and of an improved quality is likely to increase.

Note that real savings sustain various individuals that are engaged in the various stages of production. The state of the demand for money cannot increase the amount of final consumer goods produced – only the expansion in the pool of real savings can boost the production of these goods.

Likewise, an increase in the supply of money does not have any power to grow the real economy.

Contrary to popular thinking, we suggest that a liquidity trap does not emerge in response to consumers’ massive increase in their demand for money but comes as a result of very loose monetary and fiscal policies, which inflict severe damage to the pool of real savings.

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.”

As long as the growth rate 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 tie up much more consumer goods than the amount it releases. (The consumption of final consumer goods exceeds the production of these goods).

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 individuals that are employed in the various stages of the production structure, resulting in the economy plunging into a slump.

Once the economy falls into a recession because 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, they will deplete the pool of real savings further, thereby prolonging the economic slump.

The shrinking pool of real savings exposes the erroneous nature of the commonly accepted view that loose monetary and fiscal policies can grow an economy.

The fact that central bank policies become ineffective in reviving the economy is not due to the liquidity trap, but because of the decline in the pool of real savings. This decline emerges due to loose monetary and fiscal policies.

The ineffectiveness of loose monetary and fiscal policies to generate the illusion that the central authorities can grow an economy has nothing to do with the liquidity trap. We suggest that the policy ineffectiveness is always relevant whenever the central authorities are attempting to “grow an economy”. The only reason why it appears that these policies “work” is because the pool of real savings is still expanding.

Conclusion

Contrary to the popular thinking, 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 previous loose monetary and fiscal policies have depleted the pool of real savings.

Hence setting a higher inflation target once economy has fallen into a liquidity trap as suggested by some commentators, will only weaken the pool of real savings further and likely guarantee that the economy is going to stay in a depressed state for a prolonged time.

We suggest that the policy ineffectiveness is always present when the central authorities are attempting to grow an economy. The only reason why the illusion that central authorities can grow an economy appears to be real because of a still expanding pool of real savings.