Liquidity traps are one of those obscure concepts hidden into macroeconomics books. Obscure enough to occupy some marginal comment only and disputed enough to be denied by the Austrian School of Economics. Ludwig von Mises would label them as myths. But, as mytical as a black swans that have recenty decided to come out of their closets and start teambuilding in the Thames, are we going to face this myth soon as well?
When Sir John Hicks thought of the IS-LM model, he already thought of liquidity traps somehow, but it was the first Baron Keynes (also known as John Maynard Keynes) who shaped the concept (did Ludwig von Mises need a better reason to label them as myths?).
The idea is simple. With the IS-LM model, cutting the interest rate is the scape from any recession, as we make more money available into the system to boost growth and employment. But, does more available money always equate more growth?
There’s a obvious limit to this: interest rates cannot be negative (hmmm, let’s leave it like this for a minute…) so there’s obviously a limit to monetary policies, that is when rates reach zero. Are we there yet? Well, the following table borrowed from Bloomberg can help:
Regardless of the fact that we are getting there, what if the rate where monetary policy became ineffective was not zero but higher? That’s in fact the idea behind liquidity traps. What if the banks and the firms -in short, people- became risk averse enough that they preferred the liquidity of cash to offering it to others at low rates?
In other words, what happens if the free-risk situation is no longer perceived as risk-free? How should this extra aversion to lending be rewarded?
The conclusion from Keynes was that there would be a point where monetary policies would be ineffective and the economy would remain trapped in recession. Then only fiscal policy, that would be a lot of government spending, would do the trick. But are we psicologically prepared for this extra spending and increased budget deficit and debt? Will the debt attract enough financing? Will the solution even deepen the liquidity trap by substracting even more money from the private sector?
There’s still a way to have negative interest rates and that’s thanks to inflation. After all with inflation our money inside the sock loses value every day. And an expansive monetary policy should raise inflation. (hmmm, look at inflation dropping and that other scary, even mytical word too: deflation) Even though, with a low enough interest rate, and with the current global scare, many people may choose to still leave it there.