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News Link • Economy - Economics USA

Global Grand Policy Failure: Liquidity Traps and Financial Black Holes

What is a liquidity trap? Here's Wikipedia's definition: The liquidity trap, in Keynesian economics, is a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply. Liquidity traps typically occur when expectations of adverse events make persons with liquid assets unwilling to invest. Here's what that means in the real world. I have $100 in liquid assets, i.e. cash, I saved from my income. I could leverage that by borrowing $1,000 at low interest and devoting the $100 to service that new debt ( i.e. make a future monthly payment), but since my future income is in doubt, I have no desire to take on more debt, even at zero interest. How do I know if my income will enable me to pay back the principal? I could spend the $100 on discretionary purchases, but since I have everything I need to get by and my future income is doubtful, I prefer the security of savings over the marginal return of owning more gewgaws. I could use it to hire an assistant (presuming I'm self-employed or in business), but since revenues have been unpredictable, I'd rather work a few extra hours myself and keep the $100. I could spend the $100 on some new software that might make me more productive, but why bother when business is at best flatlined and at worst, in a freefall? That's a liquidity trap: those with cash and the ability to borrow have no desire to either spend or invest in new employees or business assets. Their cash (liquidity) is "trapped" in the sense they have no desire or need to spend it or invest it. In standard Keynesian economics, the only thing holding back a tide of spending and investing is lack of faith in future growth. This is of course wrongheaded. Keynesianism is blind to the black hole of debt: at a certain threshold (event horizon), the ability and/or willingness to borrow more vanishes. No amount of monetary easing or shoveling new money into banks can spark new debt and spending.

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