Best of the Week
Most Popular
1. Gold vs Cash in a Financial Crisis - Richard_Mills
2.Current Stock Market Rally Similarities To 1999 - Chris_Vermeulen
3.America See You On The Dark Side Of The Moon - Part2 - James_Quinn
4.Stock Market Trend Forecast Outlook for 2020 - Nadeem_Walayat
5.Who Said Stock Market Traders and Investor are Emotional Right Now? - Chris_Vermeulen
6.Gold Upswing and Lessons from Gold Tops - P_Radomski_CFA
7.Economic Tribulation is Coming, and Here is Why - Michael_Pento
8.What to Expect in Our Next Recession/Depression? - Raymond_Matison
9.The Fed Celebrates While Americans Drown in Financial Despair - John_Mauldin
10.Hi-yo Silver Away! - Richard_Mills
Last 7 days
The Past Stock Market Week Was More Important Than You May Understand - 31st Mar 20
Coronavirus - No, You Do Not Hear the Fat Lady Warming Up - 31st Mar 20
Life, Religions, Business, Globalization & Information Technology In The Post-Corona Pandemics Age - 31st Mar 20
Three Charts Every Stock Market Trader and Investor Must See - 31st Mar 20
Coronavirus Stocks Bear Market Trend Forecast - Video - 31st Mar 20
Coronavirus Dow Stocks Bear Market Into End April 2020 Trend Forecast - 31st Mar 20
Is it better to have a loan or credit card debt when applying for a mortgage? - 31st Mar 20
US and UK Coronavirus Trend Trajectories vs Bear Market and AI Stocks Sector - 30th Mar 20
Are Gold and Silver Mirroring 1999 to 2011 Again? - 30th Mar 20
Stock Market Next Cycle Low 7th April - 30th Mar 20
United States Coronavirus Infections and Deaths Trend Forecasts Into End April 2020 - 29th Mar 20
Some Positives in a Virus Wracked World - 29th Mar 20
Expert Tips to Save on Your Business’s Office Supply Purchases - 29th Mar 20
An Investment in Life - 29th Mar 20
Sheffield Coronavirus Pandemic Infections and Deaths Forecast - 29th Mar 20
UK Coronavirus Infections and Deaths Projections Trend Forecast - Video - 28th Mar 20
The Great Coronavirus Depression - Things Are Going to Change. Here’s What We Should Do - 28th Mar 20
One of the Biggest Stock Market Short Covering Rallies in History May Be Imminent - 28th Mar 20
The Fed, the Coronavirus and Investing - 28th Mar 20
Women’s Fashion Trends in the UK this 2020 - 28th Mar 20
The Last Minsky Financial Snowflake Has Fallen – What Now? - 28th Mar 20
UK Coronavirus Infections and Deaths Projections Trend Forecast Into End April 2020 - 28th Mar 20
DJIA Coronavirus Stock Market Technical Trend Analysis - 27th Mar 20
US and UK Case Fatality Rate Forecast for End April 2020 - 27th Mar 20
US Stock Market Upswing Meets Employment Data - 27th Mar 20
Will the Fed Going Nuclear Help the Economy and Gold? - 27th Mar 20
What you need to know about the impact of inflation - 27th Mar 20
CoronaVirus Herd Immunity, Flattening the Curve and Case Fatality Rate Analysis - 27th Mar 20
NHS Hospitals Before Coronavirus Tsunami Hits (Sheffield), STAY INDOORS FINAL WARNING! - 27th Mar 20
CoronaVirus Curve, Stock Market Crash, and Mortgage Massacre - 27th Mar 20
Finding an Expert Car Accident Lawyer - 27th Mar 20
We Are Facing a Depression, Not a Recession - 26th Mar 20
US Housing Real Estate Market Concern - 26th Mar 20
Covid-19 Pandemic Affecting Bitcoin - 26th Mar 20
Italy Coronavirus Case Fataility Rate and Infections Trend Analysis - 26th Mar 20
Why Is Online Gambling Becoming More Popular? - 26th Mar 20
Dark Pools of Capital Profiting from Coronavirus Stock Markets CRASH! - 26th Mar 20
CoronaVirus Herd Immunity and Flattening the Curve - 25th Mar 20
Coronavirus Lesson #1 for Investors: Beware Predictions of Stock Market Bottoms - 25th Mar 20
CoronaVirus Stock Market Trend Implications - 25th Mar 20
Pandemonium in Precious Metals Market as Fear Gives Way to Command Economy - 25th Mar 20
Pandemics and Gold - 25th Mar 20
UK Coronavirus Hotspots - Cities with Highest Risks of Getting Infected - 25th Mar 20
WARNING US Coronavirus Infections and Deaths Going Ballistic! - 24th Mar 20
Coronavirus Crisis - Weeks Where Decades Happen - 24th Mar 20
Industry Trends: Online Casinos & Online Slots Game Market Analysis - 24th Mar 20
Five Amazingly High-Tech Products Just on the Market that You Should Check Out - 24th Mar 20
UK Coronavirus WARNING - Infections Trend Trajectory Worse than Italy - 24th Mar 20
Rick Rule: 'A Different Phrase for Stocks Bear Market Is Sale' - 24th Mar 20
Stock Market Minor Cycle Bounce - 24th Mar 20
Gold’s century - While stocks dominated headlines, gold quietly performed - 24th Mar 20
Big Tech Is Now On The Offensive Against The Coronavirus - 24th Mar 20
Socialism at Its Finest after Fed’s Bazooka Fails - 24th Mar 20
Dark Pools of Capital Profiting from Coronavirus Stock and Financial Markets CRASH! - 23rd Mar 20
Will Trump’s Free Cash Help the Economy and Gold Market? - 23rd Mar 20
Coronavirus Clarifies Priorities - 23rd Mar 20
Could the Coronavirus Cause the Next ‘Arab Spring’? - 23rd Mar 20
Concerned About The US Real Estate Market? Us Too! - 23rd Mar 20
Gold Stocks Peak Bleak? - 22nd Mar 20
UK Supermarkets Coronavirus Panic Buying, Empty Tesco Shelves, Stock Piling, Hoarding Preppers - 22nd Mar 20
US Coronavirus Infections and Deaths Going Ballistic as Government Start to Ramp Up Testing - 21st Mar 20
Your Investment Portfolio for the Next Decade—Fix It with the “Anti-Stock” - 21st Mar 20
CORONA HOAX: This Is Almost Completely Contrived and Here’s Proof - 21st Mar 20
Gold-Silver Ratio Tops 100; Silver Headed For Sub-$10 - 21st Mar 20
Coronavirus - Don’t Ask, Don’t Test - 21st Mar 20
Napag and Napag Trading Best Petroleum & Crude Oil Company - 21st Mar 20
UK Coronavirus Infections Trend Trajectory Worse than Italy - Government PANICs! Sterling Crashes! - 20th Mar 20
UK Critical Care Nurse Cries at Empty SuperMarket Shelves, Coronavirus Panic Buying Stockpiling - 20th Mar 20
Coronavirus Is Not an Emergency. It’s a War - 20th Mar 20
Why You Should Invest in the $5 Gold Coin - 20th Mar 20
Four Key Stock Market Questions To This Coronavirus Crisis Everyone is Asking - 20th Mar 20
Gold to Silver Ratio’s Breakout – Like a Hot Knife Through Butter - 20th Mar 20
The Coronavirus Contraction - Only Cooperation Can Defeat Impending Global Crisis - 20th Mar 20
Is This What Peak Market Fear Looks Like? - 20th Mar 20
Alessandro De Dorides - Business Consultant - 20th Mar 20
Why a Second Depression is Possible but Not Likely - 20th Mar 20

Market Oracle FREE Newsletter

Coronavirus-bear-market-2020-analysis

Is the United States in a Liquidity Trap?

Economics / Economic Theory Jan 27, 2012 - 07:47 AM GMT

By: Frank_Shostak

Economics Best Financial Markets Analysis Article

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 when unemployment is high at low inflation.


The bottom line is that the Fed almost surely won't, and very surely shouldn't, start raising interest rates any time soon.

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 is presented in terms of a circular flow of money. Thus, 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. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

Consequently, 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 reestablishing 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 reestablishing 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 that they save less.

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

Now, contrary to popular thinking, individuals don't save money as such. The chief role of money is as a medium of exchange. Also, note that people don't pay with money but rather with goods and services that they have produced.

For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange. Again, money is just employed to exchange goods and services.

To suggest then 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 more or less definite 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 the 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 we suggest that 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.

Liquidity Trap and the Shrinking Pool of Real Savings

As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and nonproductive 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.)

Needless to say, 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.

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

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 the US economy is trapped, not because of a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings. What is required to fix the economy 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

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail. See Frank Shostak's article archives. Comment on the blog.

© 2012 Copyright Frank Shostak - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules