The possibility that a liquidity trap may exist under certain conditions was first postulated by Keynes (1936) with reference to the Great Depression of the 1930s. After WWII interest in the topic of liquidity trap receded, and it was relegated to a hypothetical textbook example. As Krugman notes that most of the modern papers which deal with the topic conclude “liquidity trap can’t happen, it didn’t happen, and it won’t happen again”. However, it did happen and even affected the mighty Japan. Figure B1 illustrates the emergence of deflation since 1998 coupled with a zero nominal interest rate since 1999.
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We shall now briefly explain what liquidity trap is. An economy is said to be in a liquidity trap when the monetary authority cannot achieve lower nominal interest rate in order to stimulate output. Such a situation can arise when the nominal interest rate has reached its zero lower bound (ZLB), below which nobody would be willing to lend. Even if the monetary authority increases money supply to stimulate the economy, people hoard money. In other words conventional monetary policies become impotent because base and bonds are viewed by the private sector as perfect substitutes. Liquidity trap usually is caused by, and in turn perpetuates deflation  . When deflation is persistent and combined with an extremely low nominal interest rate, it creates a vicious cycle of output stagnation and further expectations of deflation.
Through the course of this essay we will make an effort to evaluate the Great Recession of late 2000s, try to examine Paul Krugman’s claim that this recession led to a liquidity trap and finally propose some solutions which policymakers can incorporate in trying to deal with a liquidity trap.
The Financial crisis of 2007-2010 pose a very interesting question which will be a point of debate for many economists in the years to come: did the great recession really lead to a liquidity trap in the US? Many leading economists saw signs of a liquidity trap emerging in the US very early in the recession. Professor of Economics, Nobel Laureate, and CEPR Research Fellow Dr Paul Krugman is one of many Keynesian economists who believe that what US is going through right now is a period of Liquidity trap. He made a grim comment in October 2008 about the economic situation in these words: “The fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction”. However in order to assess this statement we need to analyse the economic indicators which encompassed the great recession.
One of the most important economic indicators to assess the impact of the recession is the industrial production. Figure– shows that during the first half of 2009 industrial production fell by 10% as compared to same half of last year. In fact figure – shows that industrial production index fell by almost 25 index points (base=2007). In addition construction spending, another critical indicator of output shows fall throughout the period. These factors do point towards the fact that output was stagnant through this recession. However we need to analyse more factors in order to come to a conclusion.
The great recession was also absorbed by stagnation in retail sales and consumption. Figure – exhibits the drop in retail sales during the recession period which characterises a perfect freefall. This is important because retail sales are an indicator of consumer spending which makes up more than two thirds of GDP. In fact personal consumption decreased by 3.4%.This is particularly interesting because the US has never seen a drop in personal consumption since the great depression; even during the recession of 2001, personal consumption never showed signs of slowing down.
On the other side, personal savings which mostly declined for the last 15 years rose from a mere 2.6% to almost 7%. Figure – shows that personal savings grew from $300 billion to $900 billion by the end of the recession. Credit card use (which makes up about 40% of consumer borrowing) also fell by 5%.
Part of the decrease in the personal consumption and industrial production can be attributed to the inflation rate and expected inflation. Figure– shows that although there was an increase in CPI (consumer price index) in the beginning of the recession, eventually there was disinflation which finally went into deflation. This is also related to and in fact influences the inflation expectations people form  . It is important to note that as people form their inflation expectations (or in this case deflation expectations) they try to delay consumption so that their purchasing power is greater in the future. This leads to rounds of delayed consumption, which results in lower production because of positive real interest rates in a liquidity trap. Inevitably this results in rise in unemployment because of stunted investment. All of these ingredients play a major role in defining a financial situation as a liquidity trap.
However one last ingredient which solves the puzzle is the interest rate. If we analyse the interest rate figures which were prevailing in the economy during the recession, it is fairly obvious that the monetary policy has been relatively ineffective if we compare it to the 2001 recession. The 10-year bond rate has been till very recently 2.5 %( it is now 3.4%). The Fed Funds rate is virtually nonexistent at the current rate of 0.18% (and has been since the last quarter of 2008). This becomes particularly alarming if we compare these figures to the savings and the consumption figures quoted earlier. The recession period shows inverse relationship of interest rates with personal savings and a direct relationship with consumption. These two facts point towards the existence of a situation similar to, if not exactly, the liquidity trap explained above.
To summarise, I have analysed the output stagnation during the recession period, the sluggish sales, personal consumption, savings, deflation and the interest rates. The results of the above analysis does point towards the hard reality that the situation US found itself in the aftermath of the recession show strong signs of the existence of a liquidity trap. Paul Krugman has been warning about the possibility of such a situation developing since the turmoil in Japan. He may be wrong in some instances but he was more right than wrong. The above conditions show that the US economy was in a paradox of thrift where desired savings exceeded desired investment.
Now that I have come to the conclusion that possibility of the liquidity trap appears reasonable, we need to analyse the possible solutions that policy makers can adopt while reacting to a liquidity trap.
The first option to consider is the Keynesian way to tackle economic instability-Fiscal policy. This was first suggested by Keynes as a remedy to the liquidity trap. His advice was that the government can always stimulate the economy in a liquidity trap by simply printing money. Krugman also supports this policy. In fact he proposes an even stronger fiscal stimulus than the current one along with an aggressive GSE lending  . Some economists have even suggested undertaking a “helicopter drop”  targeted at the Treasury.
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However there has been criticism on the US fiscal policy as the unemployment rate is much higher despite the fiscal stimulus. To this policymakers have responded saying had it not been the fiscal stimulus the final numbers would have been much worse. On the other side Krugman feared that the first fiscal stimulus was just too small in the first place given the large recessionary shock. There have also been debates about the fiscal multiplier and the relative effectiveness of tax cuts and government expenditure but research is ongoing and we will only get to know the findings later.
Another option to tackle the issue of liquidity trap is to administer Unconventional monetary policy. As interest rates touch zero, central bank needs to adopt policies other than lowering interest rates.
The first set of such policies implemented by the fed during the recession was the credit easing under which the fed reallocated its asset portfolio  . It replaced risky assets from the market with Treasury bonds in its balance sheet. The idea behind this option was to reduce risk spreads and encourage market-making in markets where trading had collapsed.
Quantitative easing was another option pursued by the fed after the collapse of Lehmann brothers. The focus shifted to pumping money in the economy. Hence, Fed expanded its balance sheet by increasing bank reserves and buying assets from the proceeds. As a result balance sheet expanded significantly. Fed assets jumped from USD 907 billion on 3-Sep-08 to USD 2.2 trillion on 12-Nov-08 and Bank Reserves from USD 10 billion on 3-Sep-08 to USD 859 billion on 31-Dec-09  .
Another policy which has emerged as a very important tool is the central bank Communications. The Fed can give a forward guidance to the markets about the Fed’s future policy moves and guides financial markets by releasing certain statements. For example the fed can direct these is “likely to warrant exceptionally low levels for the federal funds rate for an extended period”. Krugman is also a supporter of this “pre-commitment” by the Fed to keep rates low for an extended period.
Inflation targeting is another tool to create expectations. For example if the Fed announces to keep the preferred inflation estimate around 2% (core PCE) then it will lead to higher inflationary expectations and will lead to rise in industrial production and eventual decline in unemployment rate. However such a policy is difficult to implement given the present Federal Reserve Act. A variant of this strategy is the price level targeting under which there is a commitment to raise prices over a certain period rather than a commitment to raise prices every year by the same rate. The issues related with this strategy are the same as inflation targeting. Only Sweden tried it during the great depression and research shows good results.
Exchange rate targeting is another policy which suggests that Central Bank in coordination with government can take measures to depreciate the home currency. This would lead to more expensive imports and result in higher inflation. This would also push up demand as exports become cheaper compared to other countries. However this option cannot be tried as there are many countries facing the same problem of liquidity trap and it will lead to protectionism and currency wars so this option is ruled out.
The third type of policy other than fiscal and unconventional monetary policy is money financed fiscal stimulus. In this case, government starts fiscal stimulus which is financed by Fed using quantitative easing. Recent research paper by Laurence Meyer suggests that this will lower unemployment in US by 2% by 2012 and inflation will rise by 0.5% by 2013. However this hybrid of fiscal and monetary policy has the same issues regarding the idea of an independent central bank aiding a government borrowing program.
To conclude, this article(an effort has been amde in this article) analyzes the difficulties a central bank faces in such circumstances and discusses the tools/options available to monetary policymakers. Policy as usual is not an option, and the central bank’s framework for conducting policy must change. Importantly, it must change in ways that alter individuals’ expectations of what policy will be like when the zero lower bound on interest rates is no longer binding. Thus, the conduct of monetary policy becomes quite subtle and depends on the credibility of proposed future actions. Furthermore in the case for US, QE seems to be the right option. However the best solution would be a coordinated fiscal and monetary policy. Paul Krugman commented on the lowering of the Fed rate to 0-0.25% in these words: “seriously we are in very deep trouble. Getting out of this will require a lot of creativity, and maybe some luck too.” Looking at the evidence I must say that it will surely require a lot of luck.