The liquidity trap

There have been many diagnoses of what ails the economy. One of the newest ones is that the economy has been in something called a liquidity trap. It doesn’t sound good, but what is it? N.C. State University economist Mike Walden explains.

“Well, it’s not good. … And essentially what it means is that when you have an economic downturn like a recession, one of the things that policy makers do — particularly the Federal Reserve — is to push interest rates down (and) also increase the supply credit to lenders so as to encourage lending. And that will lead to increased spending. And that will lead to increase the economic activity, lower unemployment, et cetera.

“So the key here is the idea that people and businesses will respond to lower interest rates and more available credit and borrow and spend more. This is called monetary policy. However, sometimes we’re in a situation where people are so pessimistic or so fearful about the economic outlook that it doesn’t matter how low interest rates are. Or it doesn’t matter how available credit is: They simply won’t borrow. And we call that a liquidity trap.

“And many economists nalyzing the current economic situation say that’s exactly where we are today — that it doesn’t matter how low the Fed pushes interest rates — and we’ve seen them push rates very, very low — people simply aren’t going to borrow. People simply aren’t going to spend, because they are uncertain about the economic future.

“In terms of policy, what this suggests is that if you are going to use some of the levers of national economic policy — using the techniques of the Fed, the Federal Reserve has — (you) are going to be less effective than using the techniques that the government has through tax policy and spending policy (so-called fiscal policy).

“So this is a very important concept that really gives us some direction for what policy tools might be effective in helping relieve our economic situation.”