Every textbook Keynesian solution to escape the [financial] black hole of liquidity entrapment [we are in] has been tried on a grand scale, and failed on an even grander scale but the solution is simple: renounce/write down all impaired debt, wipe out the “too big to fail” banks, and restrict the reach and political power of the remaining banks and Wall Street. Until we are willing to do that, then the liquidity trap will remain a black hole that the economy cannot possibly escape. [Let me explain.] Words: 1122

 So says Charles Hugh Smith (www.oftwominds.com) in edited excerpts from an article* which Lorimer Wilson, editor of munKNEE.com (It’s all about Money!), has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Smith goes on to say:

The liquidity trap, in Keynesian economics, is a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply. Liquidity traps typically occur when expectations of adverse events make persons with liquid assets unwilling to invest. (Wikipedia)

What a Liquidity Trap Means in the Real World

I have $100 in liquid assets, i.e. cash, [that] I saved from my income. I could leverage that by borrowing $1,000 at low interest and devoting the $100 to service that new debt ( i.e. make a future monthly payment), but since my future income is in doubt, I have no desire to take on more debt, even at zero interest. How do I know if my income will enable me to pay back the principal?

I could spend the $100 on discretionary purchases, but since I have everything I need to get by and my future income is doubtful, I prefer the security of savings over the marginal return of owning more gewgaws.

I could use it to hire an assistant (presuming I’m self-employed or in business), but since revenues have been unpredictable, I’d rather work a few extra hours myself and keep the $100.

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I could spend the $100 on some new software that might make me more productive, but why bother when business is at best flatlined and at worst, in a freefall?

[In summary,] a liquidity trap [describes a situation in which] those with cash and the ability to borrow have no desire to either spend or invest in new employees or business assets. Their cash (liquidity) is “trapped” in the sense they have no desire or need to spend it or invest it.

In standard Keynesian economics, the only thing holding back a tide of spending and investing is lack of faith in future growth [but] this is, of course, wrongheaded.

[In fact,] Keynesianism is blind to:

[Because none of the above have ever been] on the Keynesian agenda, what we have instead is three failed policies, not just in the U.S. but globally [as put forth by WSJ.com in an article entitled] Finding a Prescription for the U.S.’s Money Trap: Three fixes to the “liquidity trap” :

1. the classic Keynesian prescription is for the government to borrow (after all, rates are low and savings idle) and spend to create demand and jobs.
2. Lars Svensson, now deputy governor of the Swedish central bank, sees one “foolproof way of escaping from a liquidity trap”—devalue the currency. “This will jump-start the economy and escape deflation.”
3. the interest rate that matters in the economy is the sticker-price rate adjusted for inflation. So some economists argue that the way out of the trap is for the Fed to convince everyone it’s going to create more inflation. If inflation goes up and interest rates don’t, then the inflation-adjusted interest rate falls, and that will give people cause to borrow and spend. Incomes rise with inflation, debts wouldn’t, and they’d be easier to pay off.

All three [of the above] Keynesian policies have been tried, and all three have failed completely.

Conclusion

Until we renounce/write down all impaired debt, wipe out the “too big to fail” banks, and restrict the reach and political power of the remaining banks and Wall Street…the liquidity trap will remain a black hole that the economy cannot possibly escape.

*www.oftwominds.com/blogaug11/liquidity-trap-8-11.html

Related Article:  Liquidity Trap” is Fast Approaching

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above

In the popular framework of thinking, which originates in the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings. In the Keynesian framework, the key to prosperity is the ever-expanding monetary flow. Monetary expenditure drives economic growth. Words: 542

In further edited excerpts from the original article* Frank Shostak (www.mises.org) goes on to say:

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditures and raise their savings. If, for instance, for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending. Consequently, a vicious circle sets in. The decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more.

In order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates. Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money, so it is held.

Keynes suggested, however, that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they could not fall further. This, according to Keynes, could occur because people might adopt the view that interest rates have bottomed out and that rates will subsequently rise, leading to capital losses on bond holdings. As a result, peoples’ demand for money would become extremely high, implying that they would hoard money and refuse to spend it no matter how much the central bank tried to expand the money supply.

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending could be on all sorts of projects — what matters here is that a lot of money must be pumped in order to boost consumers’ confidence. With a higher level of confidence, consumers would lower their savings and raise their expenditures, thereby reestablishing the circular flow of money.

It is interesting to note that Keynesian economic ideas have been embraced and implemented by the governments and central banks of the major economies of the world [with the Obama Administration its greatest endorser].

*http://blog.mises.org/?p=010700

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given.
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