Europe may still be stuck in a liquidity trap

Europe may still be stuck in a liquidity trap.

During the financial crisis, this economic idea came into play as economists worried the Federal Reserve’s move to buy assets couldn’t avoid this scenario, in which additional injections of money into the banking system failed to reduce interest rates such that alternative uses of this capital was best used elsewhere (i.e. buying stuff or investing in something potentially productive rather than saving).

In short, a liquidity trap is the nightmare of modern central bank policy, which is broadly underwritten by the idea that additional injections of capital will boost preferences for goods over money, thus stoking price inflation and economic activity.

And though interest rates in the US — and, at the time, Europe — were pegged at 0%, additional injections of money into the US economy for years failed to stoke inflation as this money was put into bonds — and later stocks — or simply hoarded.

As we well know, central banks in Europe and Japan have since abandoned the zero-lower bound and taken rates into negative territory while inflation and economic growth in these economies still remains elusive.

And while it has been some time since markets — in a mainstream way — have worried that we’ve fallen into a liquidity trap (thus rendering much of what central banks have or are believed to be able to do ineffective), Deutsche Bank’s rates team wrote in a note over the weekend that we shouldn’t be so sure this has been avoided.

Here’s DB (emphasis ours):

Understanding how negative rates may or may not help economic growth is much more complex than most central bankers and investors probably appreciate. Ultimately the confusion resides around differences in view on the theory of money. In a classical world, money supply multiplied by a constant velocity of circulation equates to nominal growth. In a Keynesian world, velocity is not necessarily constant — specifically for Keynes, there is a money demand function (liquidity preference) and therefore a theory of interest that allows for a liquidity trap whereby increasing money supply does not lead to higher nominal growth as the increase in money is hoarded. The interest rate (or inverse of the price of bonds) becomes sticky because at low rates, for infinitesimal expectations of any further rise in bond prices and a further fall in interest rates, demand for money tends to infinity. In Gesell’s world money supply itself becomes inversely correlated with velocity of circulation due to money characteristics being superior to goods (or commodities). There are costs to storage that money does not have and so interest on money capital sets a bar to interest on real capital that produces goods. This is similar to Keynes’ concept of the marginal efficiency of capital schedule being separate from the interest rate. For Gesell the product of money and velocity is effective demand (nominal growth) but because of money capital’s superiority to real capital, if money supply expands it comes at the expense of velocity. The new money supply is hoarded because as interest rates fall, expected returns on capital also fall through oversupply — for economic agents goods remain unattractive to money. The demand for money thus rises as velocity slows. This is simply a deflation spiral, consumers delaying purchases of goods, hoarding money, expecting further falls in goods prices before they are willing to part with their money.


In a Keynesian world of deficient demand, the burden is on fiscal policy to restore demand. Monetary policy simply won’t work if there is a liquidity trap and demand for cash is infinite. Interest rates cannot be reduced any further to stimulate demand. (In Gesell’s terminology the product of velocity and money supply i.e. effective demand keeps falling). In Gesell’s world money itself needs to be taxed to prevent hoarding and to equalise the worth of money to goods. If cash is taxed (and he suggested at the annual tax rate might be 5.2 per cent, according to Keynes) then velocity is stabilised, demand for money falls and goods demand recovers. The tendency to oversupply however in an economy unfettered by “privilege” effectively implies that interest rates in equilibrium may converge to zero. Taxing of money specifically is to deal with an ex ante effective demand deficiency.

Europe’s long time obsession with negative rates, to quote our present day Fischer, is fair but misleading in the context of how negative interest rates are being applied. The combination of penalty rates on banks’ excess reserves and QE is designed at one level to expand private sector credit. This if anything will promote supply of goods. If supply creates its own demand and or if Keynesian investment accelerator models are valid, then they may well be successful in restoring a Keynesian deficient demand problem. This is essentially the same as saying there is no liquidity trap. (If we think of the inverse bond price on the vertical axis as being a private sector asset price, then a large price rise can be achieved for a relatively small amount of money expansion). But it presupposes that there is deficient loan demand due to high money capital interest rates rather than due to too low real capital expected returns. The risk is that QE itself is simply new money being hoarded on the demand side so that money velocity falls and effective demand remains weak. Falling interest rates may well promote new loan demand and increase supply but only in a deflationary spiral of further falls in expected capital returns and the perceived need for still lower money interest rates. If Gesell is correct, it is essential to tax money itself which means not just retail deposits but cash in circulation. Then velocity would stabilise with effective demand as households would be willing to own goods rather than money. It is conceivable that the Europeans are heading in this direction and maybe it will be worse before it gets better. Or maybe there is still time for the Keynesian mechanism to prove that we are not in a liquidity trap.

Just an idle thought.

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