It’s a Liquidity Trap!

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by Griffin Lewis

If you’ve been reading economists of Keynesian persuasion, you may have heard that the US economy is in what’s referred to as a Liquidity Trap; aggregate demand is depressed, monetary policy is completely ineffective, printing money won’t cause inflation, and only government spending can end this recession. But for non-Economists the “liquidity trap” remains a mystery. Allow me to put on my Keynesian hat and explain the logic, albeit incredibly simplified.

Liquidity is cash, and everyone has a liquidity preference; we like to keep some of our money in cash (that way we can buy things) and some of our money in the bank (so it can collect interest.) When interest rates are high, saving becomes more attractive; when interest rates are low, we prefer spending. Similarly, people and businesses take out more bank loans for houses, cars, college, or business investment when the interest rate is lower.

The basic underpinning of the Keynesian economic worldview is “circular flow” – spending > income > spending > income. In recessions, when people expect the future to be bad, they save more and spend less. But when everyone tries to save at once, they damper the economic flow; businesses make less revenue and so they lay-off more workers, unemployment increases, the economy continues to look grim, and so people save even more. Keynes called this phenomenon the “paradox of thrift.” The Keynesian conclusion is simple, when demand is depressed, savings is bad and spending is good.

Normally during blips in unemployment, the Federal Reserve seeks to lower interest rates, thus increasing spending which kicks circular flow back into gear, returning employment to the natural level. The Fed cannot directly control the interest rates of private banks, but it attempts to influence the interest through the few tools it has available. (Generally, by expanding the money supply via money printing.) In deep economic recession, however, people continue to hoard cash even when interest rates are at 0%. The “paradox” is too great to overcome through monetary policy. Hence the liquidity trap!

Won’t money printing cause inflation? Not according to Keynesians; since aggregate demand is depressed, businesses are lowering prices to move merchandise and all the easy credit given to banks just sits in a vault as reserves. The problem is no one is willing to take out a loan for a house or a business. As soon as the economy gets moving again, the Fed plans to gradually raise interest rates to the equilibrium level.

Only a fiscal expansion (government spending) can get the economy out of the trap and return the circular flow to proper speed. Now a Keynesian would probably explain the logic of this very differently than I’m about to, but I think my explanation is easier to understand and elegant; every person has a marginal propensity to consume and a marginal propensity to save (which is just future spending). Let’s just say MPC = 0.8 and MPS = 0.2. When the government taxes you one dollar, they are taking 80 cents of spending and 20 cents of savings, and spending it 100%. Hence why there can be positive “multipliers” without crowding out demand in equal parts. 

Technically, the fiscal stimulus would be financed through deficits and not a tax increase, but deficits now are just tax increases later. This might seem like a broken-window fallacy because that 20% savings would have been invested or spent on something in the future, but the argument is that spending now can lift us out of the economic rut of lower-equilibrium employment. If you’re not gonna spend your money, the government will do it for you. A fiscal stimulus in a Keynesian-style liquidity trap is basically the governments saying, “You’re savings are a rainy-day fund, but the storm is here.”

So, if you believe this paradox of thrift argument, government spending is a good thing and should lift the economy. 

Of course, a Hayekian would tell you differently. 

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One comment

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