|
How Does a Liquidity Trap Affect You? |
by John Jagerson
A liquidity trap is what the European Central Bank (ECB) wants to avoid. The ECB chief stated today that although they were cutting rates to 2% they did not want to find themselves in a liquidity trap. That has lead many investors and analysts to assume that there won't be another cut for another two meetings. This should be prompting investors to ask what a liquidity trap is and how it could affect them.
A liquidity trap occurs when the central bank keeps lowering interest rates all the way to zero in an effort to stimulate the economy but the economy does not respond as desired. This can be caused by banks being reluctant to lend despite the cash injections from the central bank or from a lack of demand for capital from businesses. If that part of the chain is not working the capital or liquidity becomes trapped between the banks and the potential borrowers in the economy.
A reluctance to lend or a lack of borrowing demand can be destructive because it could lead to lower production levels, lower consumption levels and possible deflation. This kind of trap has tied the hands of the Federal Reserve in the US because (with rates close to zero) one of its primary monetary policy tools to stimulate the economy (lowering rates) has been nearly used up.
It is theoretically possible to push capital into the economy despite the reluctance of lenders and borrowers by injecting it in the form of gifts (oops, pardon me, I meant "stimulus".) In this situation the Government can push money directly into the hands of favored businesses and individuals through direct investment, bailouts, asset purchases, infrastructure contracts, etc.
There are potential problems with handling a liquidity freeze like this.
1. It can unintentionally feed the beast (bubble) that contributed to the recession by encouraging the same behavior with cheaper capital.
2. The central bank has lost one of its primary tools to manage monetary policy and (unless rates are raised) it has fewer options available to stimulate the economy in the future.
3. Artificial intervention on a large scale creates its own risk for bubbles. By artificially modifying market fundamentals the real possibility (and risk) of new asset bubbles becomes more likely.
In the next article I will go into more detail about what the risks of a liquidity trap are and how they may become opportunities for investors.
|
