Liquidity Trap: What Is to Be Done?
Major advanced capitalist economies—including Japan since the mid-1990s, and the United States, the euro area, the United Kingdom, and Canada after the 2008 global financial crisis—have experienced prolonged liquidity traps characterized by low growth, low inflation or deflation, and persistently low long-term interest rates. Paul Krugman and Ben Bernanke have argued that, by lowering real interest rates and reviving inflation expectations, a central bank’s credible commitment to sustained monetary easing is sufficient to escape such traps. Drawing on John Maynard Keynes’s theory of liquidity preference, this paper contends that monetary easing, while possibly necessary, is not sufficient for recovering from a liquidity trap. As interest rates fall, the duration and convexity of long-term bonds rise, heightening investors’ fear of capital losses and reinforcing the preference for cash. A liquidity trap reflects a breakdown between investment expectations and effective demand under fundamental uncertainty. It is argued here that overcoming a liquidity trap requires a three-pronged strategy that includes: (1) yield curve stabilization to reduce interest rate volatility, (2) expansionary fiscal policy to directly support effective demand and employment, as well as revive animal spirits, and (3) Schumpeterian structural reforms to foster creative destruction, new industries, new products and services, and productivity growth. The paper concludes that a coordinated monetary-fiscal-structural strategy, rather than merely accommodative monetary policy, is necessary to durably escape a liquidity trap.
