A financial crisis initiates a sudden flight to safety among bondholders – widening interest-rate spreads, diminishing the private sector’s desire to sell bonds to raise capital and encouraging individuals to save more and consume less as they, too, hunker down. Thus bond prices rise, and interest rates drop. As rates fall, firms see that they can get capital on attractive terms and so issue more bonds; households see the low interest rate earned on their savings and lose some of their desire to save. The market heads toward equilibrium.
The Safeguarding of Wealth and the Fall of the Velocity of Money
But something else happens on the path to equilibrium. The decline in interest rates and the rise in savings are accompanied by an increased desire among businesses and households to safeguard more of their wealth in cash. As a result, the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, workers are fired, and their savings evaporate with their incomes.
Thus the equilibrium turns negative, with high unemployment and low capacity utilization.
In responding to a small financial disruption, the Federal Reserve can inject more money into the economy by buying bonds for cash, increasing the amount of cash so that even at the lower velocity of money we retain the same volume of spending. This eases the decline in interest rates, spending, employment and production into a decline in interest rates alone.
Little Difference Between Cash and Short-Term Government Bonds
But when rates become so low that there’s little difference between cash and short-term government bonds, open-market operations cease having an effect; they simply swap one zero-yielding government asset for another, with their hunger to hold more safe, liquid assets unsatisfied.
A Liquidity Trap
This is the liquidity trap.
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 (e.g., deflation, insufficient aggregate demand, or civil or international war) make persons with liquid assets unwilling to invest.
In this situation we need deficit spending. The government spends and borrows, creating more of the safe, cashlike assets that private investors want. As these bonds hit the market, people who otherwise would have socked their money away in cash – diminishing monetary velocity and slowing spending – buy bonds instead. A large, timely government deficit thus short- circuits the adjustment mechanism, avoiding the collapse in monetary velocity.
As long as output remains depressed and there is slack in the economy, printing more bonds will have negligible effect in increasing interest rates.
The prices of inflation-protected bonds suggest that the market expects the new Treasury issues to be devoured without any acceleration in inflation.
Related Information in Prosperity View
- Quantitative Easing – Interest, Inflation Rate Tradeoff
- Financial Planning to Improve Cash Flow and Build Net Worth
- Our Low Savings Rate – Is our Government an Enabler?
- Dollar will Drop so Don’t Invest in Dollar Assets – Marc Faber
- Buy an Annuity and Delay Social Security – GAO
- Expectations For A Higher Savings Rate May Need To Be Tempered | How Frugal Have We Become?
- Attempt to Reduce Debt is Difficult and Impacts Global Economy
- Saving Money – Start the New Year With an Attitude to Save Money
