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Liquidity Traps: Old and New

By Hassan Shirvani—-

The concept of a liquidity trap, introduced by the British economist John Maynard Keynes during the Great Depression of the 1930s, refers to the situation in which monetary policy becomes largely impotent in lowering interest rates to stimulate additional borrowing and spending in the economy. This can result from the fact that during the times of deep economic and financial crises, many investors tend to avoid risky investments in favor of such safer assets as cash and government bonds. This massive flight to safety can raise the prices of such assets and, hence, push their yields close to zero. Under these conditions, any further monetary expansion will be of limited use, since most of the additional money injected into the economy will be hoarded with little or no impact on interest rates. In addition, as Keynes argued, even if monetary ease can lower interest rates, it is doubtful that many consumers and businesses will engage in borrowing and spending, given their depressed animal spirits during severe economic crises. Thus, given the impotency of monetary policy during liquidity traps, Keynes recommended a greater reliance on fiscal policy, urging governments to borrow and invest the available idle balances themselves.


The earliest documented case of a liquidity trap is usually associated with the Great Depression of the 1930s, during which the repeated attempts of the Fed to trigger an economic recovery through easy monetary policy were largely unsuccessful. The bulk of the money supply provided by the Fed was hoarded both as excess reserves by banks and as cash holdings by fearful investors. Indeed, it was only the entry of the US into the Second World War and the related war expenditures that finally pulled the US economy out of the Depression. This important lesson, however, was soon lost to both economists and policymakers in the course of the next few decades after the War, as the world economy experienced a long period of relative stability and growth.


The liquidity trap reappeared in the 1990s in Japan, however, as the stock and real estate market crashes of the early 1990s created an urgent need for monetary expansion. This time, too, massive monetary interventions by the Bank of Japan, while helping to stabilize the Japanese financial system, failed to make any significant impact on either Japanese prices or output. Indeed, for almost two decades, Japan continued to face persistent deflationary pressures, raising further doubts about the relevance of monetary policy. Interestingly, and despite the glaring failure of monetary policy to cure the Japanese recession, many Western economists continued to pressure Japan into adopting an even more expansionary monetary policy. A few economists, however, pointed out the presence of a liquidity trap in Japan as the main culprit in economic stagnation, thus calling for more active fiscal policy.


The recent financial crisis has again served to bring the liquidity trap as a relevant and potentially debilitating economic condition into sharp focus. Since the onset of the crisis in 2008, the Fed has quadrupled the monetary base in America (from $800 to $3,400 billion), which while effective in preventing a financial meltdown, has done relatively little to stimulate the economy. In addition, similar attempts by other central banks around the world have fared not much better. The reason for this failure, as was the case for earlier liquidity traps, is clear: most of the cash injected by central banks into their economies is sitting in the vaults of their commercial banks gathering dust. Banks are reluctant to lend, and private spenders are reluctant to borrow. Once again, only fiscal actions by governments can save the day by lifting the depressed economies out of their liquidity traps. This was true in the US of the 1930s, it was true in the Japan of the 1990s, and it is certainly true for the global economy of today.

Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics

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