Perhaps the worst thing that can happen to a term in any language is that it loses completely its meaning and becomes a sort of floating signifier that can attach itself to any old nonsense. Such is the case today with the term “liquidity trap”. In contemporary parlance, “liquidity trap” means something like the situation many countries have faced since 2008; that is, a situation in which central banks have lowered interest rates right down to the zero-bound level and the economy fails to respond.
It is certainly clear why this might be considered a sort of “trap”, but why on earth would it be considered a “liquidity” trap? Few today seem to stop to think about the actual meaning of the two words in this term in any depth at all, so busy are they debasing the words in the English language as if they were so many clipped coins.
“Liquidity trap”. Well, that must be a trap caused by liquidity. Is it then a trap caused by too much liquidity? Surely not. That would imply that the central banks created our current so-called liquidity trap by creating too much money, but clearly modern day liquidity trap proponents like Paul Krugman do not think this. They think that the central bank has hit a limit to the amount of effectiveness money creation can have. The “trap” comes from elsewhere then.
So, from where does it come? Well, the modern day liquidity trap proponents seem to imply that in our current environment the demand for money becomes perfectly elastic – that is, no matter how much money the central banks create it is simply soaked up by thirsty hoarders. Hence the trap – not one caused by liquidity, but instead one in which people become desperate for liquidity.
In fact, this is precisely what the originator of the term, John Maynard Keynes, and his followers actually thought that a liquidity trap was. Here is the original quote on the liquidity trap from Keynes’ General Theory of Employment, Money and Interest:
There is the possibility … 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. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.
Note carefully what Keynes is saying here. He is saying that in the event of a liquidity trap the rate of interest would fall outside the dictates of the central bank. The bank would pump money into the system and interest rates would fail to come down because people would simply hold cash. This is absolutely not happened in the post-2008 world, where yields across the board fell in response to the money creation programs like QE.
Keynes’ follower Hyman Minsky used the liquidity trap argument in the correct manner and gave it a sharper form; one which, unlike the form used by the pseudo-Keynesians, actually seeks to elucidate something rather than create a fog of unmeaning. Here is a quote from his book Stabilizing an Unstable Economy:
After a debt deflation that induces a deep depression, an increase in the money supply with a fixed head count of other assets may not lead to a rise in the price of other assets. (Stabilizing an Unstable Economy, p202)
So, what happens in such a scenario? Well, interest rates on assets that are not considered almost perfectly liquid rises sharply. Here is Minsky from his earlier book John Maynard Keynes:
The view that the liquidity-preference function is a demand-for-money relation permits the introduction of the idea that in appropriate circumstances the demand for money may be infinitely elastic with respect to variations in the interest rate… The liquidity trap presumably dominates in the immediate aftermath of a great depression or financial crisis. (John Maynard Keynes, p36)
Read that carefully. The liquidity trap dominates then in the “immediate aftermath” of a financial crisis. What we would expect to see in an actual liquidity trap is prices falling on assets that are not considered perfectly safe and, conversely, interest rates rising on those same assets. Meanwhile, assets that are considered perfectly safe – like Treasury Bills – should see their prices rise and their interest rates fall.
And that is precisely what we saw in the immediate aftermath of the 2008 crisis as can be seen from the TED Spread below which is the spread between the LIBOR rate, the rate at which banks typically lend to one another, and the three-month Treasury Bill rate, which is the value placed on perfectly safe assets.
There is your liquidity trap. But as we can also see from the graph, we exited the liquidity trap rather quickly – we were out by late 2009 – and as the quantitative easing programs were stepped up asset prices rose across the board and interest rates fell. The world we then entered was indeed a strange one. But to characterise it as a sort of perpetual liquidity trap, as the likes of Krugman and the pseudo-Keynesians do, is completely outlandish.
A liquidity trap does not exist unless the prices on imperfectly safe assets are falling and their interest rates are rising. This is not the world we have lived in since 2008 and so this world is not one of a liquidity trap. The only reason anyone thinks otherwise is because they are sloppy thinkers who, frankly, do not understand what they’re talking about or even the words they use to express themselves. They seem to want to create a rationalisation for why monetary policy – which they hold as the superior tool of economic management – fails. But the real reason it failed was because it was never a particularly good tool for macroeconomic stabilisation in the first place. It had nothing to do with some extended period of the economy remaining in a liquidity trap. And if the pseudo-Keynesians must come up with fancy sounding terms for monetary policy’s failure after the crisis, could they kindly make up these terms themselves and not spoil the ones we already have?
Fixing the Economists 
Tsk. You have to remember that in the hands of economists all words are humpty-dumpty words. Partcularly if you have a ‘nobel prize’ and even more so if you have a beard and a nobel prize.
Indeed. I do wish they would make up their own words though. When they bastardise others they just end up not making any sense. They could call the failure of monetary policy a “ZIRP trap” or a “lending trap” or whatever. So many words to come up with. But I think they have to lend it authority by pretending it sits with older economic theories.
This is a useful post for me. I don’t tend to think in terms of liquidity traps, but I’ve been rather puzzled by recent references to it, so it’s good to read your views on this.
When I did high school economics, I was taught that a liquidity trap arose in relation to the portfolio choice between non-interesting bearing money and interest bearing long-term bonds. This was not necessarily a credit issue, in that the bonds could be government issued and considered perfectly safe, but rather one of liquidity as money invested in bonds is supposedly tied up for some time.
Of course, government bonds are actually highly liquid, but the risk is always that you have to sell them at a loss. So the idea was that the risk of selling at a loss meant that, at some low level of interest rate (and therefore high price), investors would not want to hold bonds at all, because of a fear that the price could only go one way. This would effectively place a floor on the bond rate.
Now, I’ve never found this a very useful idea. It might have made some sense in Keynes’ time – I don’t know. But, in today’s financial market, where most money is interest bearing and most bond-holders are matching term liabilities, the dynamic seems rather different. I can imagine a position where an increase in money balances (say through QE) fails to impact on the bond price, but this comes down more to market expectations than investor preference.
Anyway, whether or not this is a useful concept, it seems to relate specifically to the distinction between money and non-monetary assets, rather than between safe and non-safe assets. Clearly these are not the same: non-monetary assets such as treasuries may be considered safe; monetary assets, such as short term deposits with commercial banks may be considered unsafe. When Keynes talks about the monetary authority having lost control of the interest rate, this seems to me to refer to the interest rate on non-monetary assets generally; rather than the credit spread between safe and unsafe assets.
Having said that, I can’t be sure that what I learnt (or at least what I remember having learnt) is really what a liquidity trap is supposed to mean, so maybe all this does is prove your point about the confusion over the term. I think I’ll just go back to ignoring it.
Totally agree with all your points.
The problem with the mainstream story is that the ISLM only has one interest rate — that for government bonds. In reality there are many interest rates. In the General Theory I think Keynes is aware of this subtlety. So, I think the liquidity trap makes sense because in normal times a fall in the rate of interest on bonds will effect the rest of the markets. In a liquidity trap the fall in the interest rate on bonds may not effect the other markets. Thus interest rates get “stuck”. I think this is what happened in 2008.
ISLM cannot account for this because it doesn’t even discuss other markets. And the world is not in an ISLM liquidity trap because the bond rate of interest did respond to Fed easing. And quite rapidly at that. So, the bond rate of interest never got “stuck”. Other rates of interest did, however, immediately after the crisis but this subsided by 2009.
Excellent
Thanks. You’re now officially on my list of go-to authors. Very elucidating.
Since a ‘liquidity trap’ is somewhat ambiguous or perhaps means something different in different contexts, the question to ask is how deep is the ‘liquidity trap?’ But first, there is need for a few clarifications. The Fed has set a low interest rate on loans which is supposed to have the effect of increasing loans and therefore the amount of money in circulation. I have that this amount is 6 times over what is was before the Crisis. Then, the Fed was buying back bonds which has the double effect of reducing government debt and increasing the money supply. What have the paid-off bondholders done? Also, if this QE strategy is considered effective in reducing debt, and corporations then also buy back their stocks, what are the paid off stockholders doing with their liquidity?
My pet peeve is that new stockholders are hard to find because of the obfuscation over transaction fees, loan regulations and taxes but the index funds are continuing to increase in this bull market. So, it is somewhat perplexing how there is a liquidity trap and a bull market unless the reason for low interest rates is due to the increased leverage requirements on banks when they issue loans.