Avoiding a Liquidity Trap

By E. Ralph Hostetter

The Federal Reserve Bank, in another effort to stimulate the nation's economy, reduced its target range for overnight interest rates from zero to 0.25 percent, the lowest level on record. Reductions in Fed rates are reflected in lower bank rates across the nation. As expected, stock markets have reacted positively overall.

Waiting in the wings may be less good news. Zero-percent interest rates may sound great but they invariably carry very dangerous, unintended consequences, one of which is a condition known as a liquidity trap. The classic definition of a liquidity trap is a condition that occurs when the nominal interest rate is close to or equal to zero. At the zero point, the monetary authority, in this case the Federal Reserve, finds itself unable to stimulate the economy.

Normally, the Federal Reserve can stimulate the economy by lowering interest rates or increasing the monetary base. These actions in turn increase borrowing and lending, spending and investing. However, with interest rates near zero, the Federal Reserve can no longer lower rates to stimulate the economy.

The Federal Reserve is left with one choice: to print more money. The money must now find its way into the economy. Traditionally, this course is through the banking system. However, in a liquidity-trap environment with banks unwilling to lend — as in the case of Japan in the 1990s, where new money went into bank reserves — the newly created liquidity is trapped behind unwilling bank lenders, thus forming the liquidity trap.

Traditionally, the Federal Reserve Bank uses interest rates as one of its monetary tools to stimulate and influence conditions involving the flow of currency. Reductions in interest rates traditionally have created a flow of cash to provide liquidity as banks with cash surpluses make available money for other banks to borrow to improve their balance sheets.

Such transactions virtually have disappeared as lending banks became more aware of problems which may exist on the balance sheets of borrowing banks. Consequently, lending banks are hoarding their cash rather than taking risks.

With the economy entering an uncertain period, other potential problems are arising. Property values are declining. The Department of Labor reported consumer prices dropped 1.7 percent in November 2008, the largest one-month decline in 61 years — since February 1947. According to the Department of Commerce, new home construction was down 18.9 percent in November, the biggest drop since March 1984. Consumer spending is down, particularly on big-ticket items such as automobiles, appliances and electronics. Unemployment has reached 6.7 percent. Job losses totaled 533,000 in November alone.

The risk of deflation has appeared. None of these warning signs has escaped the attention of Ben S. Bernanke, Chairman of the Board of Governors of the Federal Reserve. One could say the present situation is his “cup of tea.”

Described as a student of the Great Depression of the 1930s, as well as of Japan’s lost decade in the 1990s, he is aware of the risks and rewards presented by zero percent interest rates and the resulting liquidity trap. In a paper delivered in 1999, then-Professor Bernanke offered a remedy to the government of Japan, advancing the theory that a “more expansionary monetary policy was needed.” Under what is known as “a policy of quantitative easing,” the banking system of Japan was flooded with money with the aim of easing pressure on banks, persuading them to start lending again and stop a downward spiral in prices.

Since mid-September 2008, as Chairman of the Fed, Bernanke has followed his own advice here in the United States. He has ordered the printing of billions and billions of dollars and has pumped them into the financial system of the country.

The nation awaits the results of Chairman Ben Bernanke’s bold attack on the recession.

E. Ralph Hostetter, a prominent businessman and publisher, also is an award-winning columnist and Vice Chairman of the Free Congress Foundation Board of Directors.