Liquidity trap

By THIS IS MONEY
Updated:

 

The Daily Mail City team look at the dire situation when a liquidity trap occurs - and how to get out of one...

What is it?

What makes you wake up in a cold sweat in the middle of the night? In the austere world of central banking, there is one nightmare scenario above all others. The liquidity trap.

Tell me more

Imagine you are Ben Bernanke or Mervyn King and your most powerful tool stops working - no innuendo intended. This tool is the policy rate through which you control borrowing costs across the economy.

At some point cuts in the official rate to near-zero have no positive effect on the economy, because paranoid banks are still unwilling to lend. This is a liquidity trap.

Sounds serious

It is. Liquidity traps can be accompanied by deflation. Debts become more onerous and the economy begins to grind to a halt.

Policy makers have to resort to drastic measures, referred to as 'helicopter drops', under which the government metaphorically drops free bank notes onto its citizens from a great height.

When has it happened?

John Maynard Keynes identified the concept in the context of the Great Depression. Japan experienced a liquidity trap and deflation in the 1990s, when it cut rates to nil. Right now there is a near-seizure of the banking markets, though we are not quite in liquidity trap territory yet.

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