Sam Felling                                         Keynes and the Liquidity Trap

A liquidity trap has been defined by Keynes as  “A liquidity trap is marked by the failure of injections of cash by the central bank into the private banking system to decrease interest rates .Such a failure indicates a failure in monetary policy, rendering it ineffective in stimulating the economy.” This liquidity trap effectively expresses the theoretical limit of the “Zero Lower Bound”.  Keynes theorized at this point when an economy is in a liquidity trap (and thus reached the zero lower bound) monetary policy will be ineffective because people will choose to hold cash and no artificial raise in nominal rates would have any effect on real rates. While in recent years we have seen many countries such as Japan and even our own economy experience historic lows of interest rates (Figure 1) the globe is reinventing new ways to use Monetary policy and breakthrough he “Zero Lower Bound”.

FIGURE 1

(Per Figure 1 we can see as recently as 2009 the historic lows of interest rates that have been experienced in the U.S Rates have been near zero for at least the past five years.)

Keynes believed that when society reached the Zero Lower Bound that  “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.” He thought that a small or zero return on money would bring about preferences for cash and as such would not incur further spending even if the Fed artificially raised the rates in the short term. This is the fundamental basis for his liquidity trap and the theoretical debate over a Zero Lower Bound, that people will choose to hold cash the nearer the interest rate get to zero.  However, his line of thinking came at a time where people did not trust the banks (the Great Depression) and as such keeping cash was preferable to holding money in the bank (especially when there is little profit in the banks due to low interest rates). In modern times, though a lot of this risk has been hedged. Even in the great recession the average person’s holdings in the bank were not touched.  Because there is at least a degree of trust in the banks people will leave their money in the banks even if the “gains” are small (not only to mention we live in a society that is moving to become more and more cashless), due to the inherent safeness of the banks and the costs and risks of holding cash.

If people are leaving money in the banks despite low interest rates another story can be told. Because rates are lower (and directly influence mortgage rates) the classic economic story of increased lending and borrowing due to the low rates becomes more likely.  As seen in Figure 2 we can see that

Figure 2

(Per Figure 2 total mortgage lending decreased dramatically after the great Recession, however as interest rates become closer to zero in Figure 1, lending has steadily increased over that time positively.)

after the Federal Funds Rate hit near zero before 2009, lending dropped along with it initially, but since that time lending in the mortgage market has gradually increased. While the increased lending has taken awhile and been a slow recovery, other countries are using other unconventional measures to further speed up recovery.

If the story holds true that at low rates people still chose to not hold cash, new methods can be used to utilize interest rates. While low rates and negative rates are totally different, similarities can be observed between the two. If the interest rates are negative (and the negative interest rates are being passed from the bank to those with bank holdings) people may still choose to not hold cash if the bank is safe. Furthermore, it is likely the banks will not pass down the negative rates to those who are holding money in the bank (because they want that money in the bank and don’t want massive accounts lost). Because of this the remaining option for banks is to keep as few reserves as possible and lend as much of their money as they can. Since only a fraction of their money is going to be lost to the negative interest rate, they are still making money due to the massive amounts of loans they are making. This can be potentially problematic especially when considering that  banks will really want to make loans, and they may again make sizable subprime mortgage loans. However it would be a strong way to break though the Zero Lower Bound and stimulate the economy in the short term by increasing the amount of lending and in turn increase inflation. Multiple countries across the world have already broken through by implementing negative interest rates. Some of these countries include Sweden, Denmark, Switzerland, and Japan. While negative interest rates are a new tool for Monetary Authorities to use and it is too soon to say whether the empirical evidence will support these rates, theoretically at least Keynes idea of a liquidity trap can be faulted in the society we live in today. Because people choose to still hold money in the banks regardless of rates, the fundamental basis of his argument appears at least for now, invalid.