Liquidity Trap: Definition, Causes, and Examples

What Is a Liquidity Trap?

A liquidity trap is a contradictory economic situation in which interest rates are very low (e.g., close to zero percent) and savings rates are high, rendering monetary policy ineffective.

First described by economist John Maynard Keynes, during a liquidity trap, consumers choose to avoid bonds and keep their funds in cash savings because of the prevailing belief that interest rates could soon rise (which would push bond prices down). Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline. At the same time, central bank efforts to spur economic activity are hampered as they are unable to lower interest rates further to incentivize investors and consumers.

Key Takeaways

  • A liquidity trap occurs when interest rates are very low, yet consumers nevertheless prefer to save rather than spend or invest in higher-yielding bonds or other investments.
  • It occurs when consumers make the choice to hoard cash instead of choosing higher-yielding investments like bonds because of a negative economic outlook.
  • A liquidity trap isn't limited to bonds. It also affects other areas of the economy, as consumers spend less in general. which means businesses are less likely to hire
  • This perpetuates a recession while muting monetary policy efforts to stimulate growth, since interest rates are already at or close to zero.
  • Some ways to get out of a liquidity trap include raising interest rates, hoping the situation will regulate itself as prices fall to attractive levels, or increased government spending.
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Understanding Liquidity Traps

In a liquidity trap, should a country's reserve bank, like the Federal Reserve in the USA, try to stimulate the economy by increasing the money supply, there would be no effect on interest rates, as people do not need to be encouraged to hold additional cash.

As part of the liquidity trap, consumers continue to hold funds in standard deposit accounts, such as savings and checking accounts, instead of in other investment options, even when the central banking system attempts to stimulate the economy through the injection of additional funds. High consumer savings levels, often spurred by the belief of a negative economic event on the horizon, causes monetary policy to be generally ineffective.

The belief in a future negative event is key, because as consumers hoard cash and sell bonds, this will drive bond prices down and yields up. Despite rising yields, consumers are not interested in buying bonds as bond prices are falling. They prefer instead to hold cash at a lower yield.

A notable issue of a liquidity trap involves financial institutions having problems finding qualified borrowers. This is compounded by the fact that, with interest rates approaching zero, there is little room for additional incentive to attract well-qualified candidates. This lack of borrowers often shows up in other areas as well, where consumers typically borrow money, such as for the purchase of cars or homes.

Signs of a Liquidity Trap

One marker of a liquidity trap is low interest rates. Low interest rates can affect bondholder behavior, along with other concerns regarding the current financial state of the nation, resulting in the selling of bonds in a way that is harmful to the economy.

Further, additions made to the money supply fail to result in price level changes, as consumer behavior leans toward saving funds in low-risk ways. Since an increase in the money supply means more money is in the economy, it is reasonable that some of that money should flow toward the higher-yield assets like bonds. But in a liquidity trap it doesn't, it just gets stashed away in cash accounts as savings.

Low interest rates alone do not define a liquidity trap. For the situation to qualify, there has to be a lack of bondholders wishing to keep their bonds and a limited supply of investors looking to purchase them. Instead, the investors are prioritizing strict cash savings over bond purchasing.

If investors are still interested in holding or purchasing bonds at times when interest rates are low, even approaching zero percent, the situation does not qualify as a liquidity trap.

Characteristics of a Liquidity Trap

To summarize, the following are the key characteristics of a liquidity trap:

  • Very low interest rates (at or close to 0%)
  • Economic recession
  • High personal savings rate
  • Low inflation/deflation
  • Ineffective expansionary monetary policy

Why Liquidity Traps Can Occur

While uncommon, liquidity traps can occur. Economists have proposed several reasons or precursors that can lead to one.

Deflation

Deflation occurs when prices fall and the purchasing power of money increases - making it the opposite of inflation. Deflation occurs when people choose to hold on to money rather than spend or invest it, because they believe that prices will continue to fall. Why purchase a big-ticket item today when it will be cheaper in a month - and even cheaper in two months? The result is that people increase their savings. In extreme cases, a deflationary spiral can occur, where price levels decline, leading to lower production, reduced wages, decreased demand, and continued price declines. During such a feedback loop, a liquidity trap can emerge.

Balance Sheet Recession

A balance sheet recession is an economic contraction precipitated by individuals and firms choosing to pay down existing debts rather than spend or take on new debts. This can occur when the level of outstanding debt grows large enough that both borrowers and lenders become concerned that it may not be paid back in full, creating pressure for deleveraging. Even as interest rates fall, paying down debt is prioritized and new lending and investment grind to a halt.

Low Demand From Investors

Firms raise capital by issuing debt and equity capital in the form of bonds and stock, respectively. If there is such little demand from investors to purchase these securities, then even lower interest rates will not incentivize a firm to try and issue them. Moreover, both issuers and investors may see investment as risky in a recessionary period of low aggregate demand in general.

Reluctance to Lend

Banks may also become reluctant to lend if they view the general credit landscape as high-risk. Following the 2008 financial crisis, many banks faced liquidity issues as subprime borrowers defaulted. The reaction was to greatly cut back on lending in general. Thus, even with very low interest rates, many individuals who did want to borrow nevertheless found it difficult to obtain loans as banks enforced stricter underwriting criteria and shied away from all but the highest-quality borrowers.

Curing the Liquidity Trap

There are a number of ways to help the economy come out of a liquidity trap. None of these may work on their own, but may help induce confidence in consumers to start spending/investing again instead of saving.

Governments sometimes buy or sell bonds to help control interest rates, but buying bonds in such a negative environment does little, as consumers are eager to sell what they have when they are able to. Therefore, it becomes difficult to push yields up or down, and harder yet to induce consumers to take advantage of the new rate.

  1. The Federal Reserve can actually raise interest rates, which may lead people to invest more of their money, rather than hoard it. During a recession and low inflation, however, this can be a highly risky move. This may not work, but it is one possible solution.
  2. A (big) drop in prices. When this happens, people just can't help themselves from spending money. The lure of lower prices becomes too attractive, and savings are used to take advantage of those low prices.
  3. Increasing government spending. When the government does so, it implies that the government is committed and confident in the national economy. This tactic also fuels job growth.
  4. Quantitative easing (QE). The central bank can begin injecting money into the economy to stimulate spending and artificially lower interest rates below zero by buying longer-dated government bonds as well as other securities like mortgage bonds.
  5. Negative interest rate policy (NIRP). Imposing negative interest rates - i.e., crediting interest to borrowers and deducting interest from borrowers - is a way around the zero floor on nominal interest rates. This extraordinary monetary policy tool is used to strongly encourage borrowing, spending, and investment rather than hoarding cash, which will lose value to negative deposit rates, and was used in practice in Europe and Japan following the 2008 financial crisis.

When consumers are fearful because of past events or future events, it is hard to induce them to spend and not save. Government actions become less effective than when consumers are more risk- and yield-seeking as they are when the economy is healthy. Thus, these efforts, while they may work "on paper," can fail in reality.

Real World Examples of Liquidity Traps

Starting in the 1990s, Japan faced a liquidity trap. Interest rates continued to fall and yet there was little incentive in buying investments. Japan faced deflation through the 1990s, and of 2019 still has a negative interest rate of -0.1%. The Nikkei 225, the main stock index in Japan, fell from a peak of 39,260 in early 1990, and as the early 2020s still remains well below that peak. The index did hit a multi-year high of 30,500 in mid-2022 before falling to around 27,500 just a few months later.

Liquidity traps again were thought to have appeared in the wake of the 2008 financial crisis and ensuing Great Recession, especially in the Eurozone. Interest rates were set to 0%, but investing, consumption, and inflation all remained subdued for several years following the height of the crisis. The European Central Bank resorted to quantitative easing (QE) and a negative interest rate policy (NIRP) in some areas in order to free themselves from the liquidity trap.

Is the U.S. in a Liquidity Trap?

The U.S. was thought to briefly experience a liquidity trap just following the 2008 financial crisis as interest rates fell effectively to zero while output also dropped. Because of the housing bubble, banks were unwilling to lend and shocked investors stayed away from markets, parking their assets in cash.

The American economy, however, emerged from this situation after several rounds of government stimulus and central bank QE. As of the 2020s, the economy is experiencing inflation and rising interest rates, rather than the conditions that would set up another liquidity trap. Moreover, some economists doubt that the U.S. was ever really in a liquidity trap during this period, nor any other.

Why Do People Hoard Cash in a Liquidity Trap?

People might sit on cash for one or more of several reasons: they have no confidence that they can earn a higher rate of return by investing, they believe deflation—or falling prices—is on the horizon (cash will increase in value relative to fixed assets), or deflation already exists. All three reasons are highly correlated, and under such circumstances, household and investor beliefs become a reality.

Moreover, people may want to borrow, but find that banks and other lenders are reluctant to extend credit at such low interest rates, except to the most qualified borrowers.

Does the Liquidity Trap Exist?

While there is always the theoretical fear of a liquidity trap, empirical research by economists at the Bank for International Settlements (BIS) suggests that alternative monetary policy tools like QE and negative interest rates can stimulate economic growth and investment. Indeed, analysis in a BIS working paper aptly titled. "Does the Liquidity Trap Exist?" showed that in the U.S., Japan, and Eurozone, liquidity traps were easily managed through such alternative measures. They argue that, "In such a view, the central bank's inability to lower the short-term interest rate is irrelevant, provided that it can ramp up credit supply and if at least some non-financial economic agents are credit-constrained."

The Bottom Line

First theorized by the economist John Maynard Keynes, a liquidity trap is a contradictory situation in the economy where interest rates are very low but savings is high. In other words, despite interest rates that may be at or close to 0%, people prefer to hold on to cash. There are several possible reasons and explanations from lenders tightening credit to borrowers anticipating deflation. Regardless, in theory, a liquidity trap is thought to greatly limit the effectiveness of expansionary monetary policy as interest rates are already at the zero bound. Alternative tools like quantitative easing and a negative interest policy, however, have shown monetary policy to still be effective during such situations.

Article Sources
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  1. Lhuissier, Stéphane, Benoit Mojon, and Juan Rubio-Ramírez. Does the Liquidity Trap Exist?. BIS Working Paper No. 855, 2020.

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