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If you don't, you should. Because the essence of a liquidity trap is that the economy behaves very differently from how it normally behaves. In essence, it becomes like an alternate universe, where things behave in strange, counter-intuitive ways that many observers seem to find extremely difficult to grasp.

Holding on to orthodoxy is about the worst thing one can do under these circumstances.

This explains a good deal for the heated exchanges on many economic topics. There is a wonderful paper by Paul McCulley, former PIMCO partner, but this is more than 50 pages in length so we extract some of the main points here. People familiar with our writings here will recognize some of the mechanisms.

What is a liquidity trap?
Well, there are various definitions in the literature, but lets stick with the one from McCulley:

A liquidity trap is a circumstance in which the private sector is deleveraging in the wake of enduring negative animal spirits caused by the bursting of joint asset price and credit bubbles that leave private sector balance sheets severely damaged. In a liquidity trap the animal spirits of the private sector cannot be revived by a reduction in short-term interest rates because there is no demand for credit.

This definition makes it near indistinguishable from Richard Koo's concept of a balance sheet recession, but we have no problem with that, as we think it's extremely useful in describing what's going on right now.

In essence, it's a condition in which the private sector (households in the case of the US, firms in the case of Japan from the 1990s onwards) are recovering from having taken on too much debt on the back of assets which value has imploded.

But McCulley uses another definition, what he calls the 'classic' definition:

a situation in which conventional monetary policy becomes impotent because the short-term, nominal interest rate reaches the zero lower bound.

This is the definition used by Keynes himself, and Keynesians like Krugman.

Are we in a liquidity trap?
On the basis of the "zero bound" definition, this is a rather unequivocal yes. However, lets ponder some of the mechanics. So, in order to repair balance sheets, households borrow and spend less and save more. This results in lower demand, so the economy operates way below its capacity and there is a lot of unemployment and underemployment.

The above scenario becomes a liquidity trap at the moment interest rates (at the short end of the maturity spectrum) hitting zero without leading to much, if any, of a revival in credit demand. Households cut borrowing to pay off debts, the resulting loss in spending leads also to weak credit demand from firms (most of the bigger ones are awash in cash anyway and profits are good).

That means, even at zero interest rates, credit supply exceeds credit demand. Is this the case? Well, exhibit 1 shows how private sector saving minus private sector investment moved hugely positive, that is the private sector has a savings glut, despite the low interest rates.

Exhibit 2 shows how banks are stuffed with excess reserves. They have plenty of reserves to increase lending, but despite ultra low interest rates, credit demand isn't taking this up.

Monetary policy doesn't work in a liquidity trap
To revive credit demand, rates should fall further as savings hugely exceed investment and banks are stuffed with reserves. But, essentially at zero, rates can't fall further. That's the essence of a liquidity trap. Monetary policy is powerless, at least when used in isolation.

The paper does mention what it calls the "modern," expectations based view of monetary policy, according to which monetary policy isn't powerless in a liquidity trap insofar as it is able to influence inflationary expectations. This, for instance, is one of the reasons why the Fed has publicly committed to low interest rates for the next few years, but we'll leave these matters for another day.

However, quite central in the paper is McCulley's notion of how the Fed should cooperate with fiscal authorities, see below.

Paradox of thrift
Since monetary policy is supposed to regulate a "normal" business cycle, one might (indeed, should) wonder what happens when this is no longer possible. The big risk in a liquidity trap, when monetary policy can no longer do much, that the downward draft in the economy continues unabated.

When households decrease borrowing and spending to pay off debt, companies sell less and have to lay-off employees and/or reduce prices. They will also invest less, cutting demand for goods and services even more. The reduced spending, output, and employment can easily become a self-reinforcing loop, a vicious cycle, or "downward spiral."

This results in the famous paradox of thrift. Everybody tries to save more, which results in less spending and less output, hence less income, reinforcing the incentive to save more and leaving everybody worse off in the process. What is rational from an individual point of view (an overleveraged household) becomes dysfunctional at the level of the economy as a whole.

Debt-deflationary spiral
It can easily get even worse. The above negative spiral can result in falling prices. At this point market enthusiast might think that this could revive demand and break the vicious cycle but it's likely that wages will fall in tandem (this indeed happened during the 1930s).

What's more, falling prices are even more dangerous on another level. If there is still a lot of debt on balance sheets, falling prices only result in increasing the real value of that debt (as debt is a nominal concept). This is what happened in the 1930s, when prices fell rather precipitously.

Bank balance sheets
Worsening private sector balance sheets will, at some point, have an effect on bank balance sheets. In the U.S., much of this goes via the housing market with house prices tumbling while debt remained and became more difficult to service. The U.S. was rather swift in policy reaction so the financial system has survived, but from historical episodes we know that bank runs are not at all uncommon in these kind of circumstances.

Money creation doesn't cause inflation
From McCulley:

Critics invoke the orthodoxy that printing money is inflationary. But in a liquidity trap it is not. Money is as money does, and judging from the trillions in excess reserves on banks' balance sheets, money isn't doing anything. Printed money is unlikely to become inflationary until after the private sector has finished deleveraging and is bidding for funds again.

You'll see in the figure above that very expansionary monetary policy hasn't created any acceleration in inflation, despite the enormous run-up in bank reserves (see figure above) and people predicting hyperinflation for years.

Government borrowing doesn't crowd out the private sector
Since there are plenty of funds available for borrowing as the private sector is deleveraging and there are plenty of idle resources in the economy that operates well below full capacity, this isn't any worry, another orthodoxy that falls by the wayside under a liquidity trap.

Fiscal policy is the only thing that works
Here is McCulley again:

However, deleveraging is a beast of a burden that capitalism cannot bear alone. At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

But in order to overcome orthodoxy, fiscal policy needs 'help' from the central bank.

Central Bank independence
Another orthodoxy that has to be relaxed, after all, the paper is titled "Does Central Bank Independence Frustrate the Optimal Fiscal-Monetary Policy Mix in a Liquidity Trap?" McCulley argues that both have to work in conjunction as both in isolation are a lot less effective.

Orthodoxy might very well hold back the government from borrowing and spending, and by keeping rates as low as possible one hurdle is lowered. Also:

Moreover, by replacing interest-bearing debt with money, central bank purchases of government debt would lower current deficits and interest burdens and thus expectations of future tax obligations. The fiscal authority's Concerns of Ricardian equivalence, crowding out and rising rates would be allayed, and the monetary authority's problem would also be solved in that the government would help repair the broken monetary transmission mechanism by becoming the willing borrower to take advantage of low rates and borrow and invest.

What not to do
Austerity is about the worst thing one can embark upon. If everybody is cutting back borrowing and spending, somebody has to spend to keep the economy from spiraling downwards (see paradox of thrift and deflationary debt spiral above). Somebody tell Europe..

Conclusion
When the economy is in a liquidity trap it behaves quite different than usual. Holding on to policy orthodoxies as austerity and keeping the money supply in check is likely to worsen, rather than improve the situation.

It isn't easy for orthodoxy to lose its grip on policy though. As Keynes himself remarked:

worldly wisdom teaches that it is better for reputation to fail conventionally, rather than to succeed unconventionally.

Source: A Crash Course In The Weird World Of A Liquidity Trap