Popular economics suggests that economic activity results from a circular flow of money in the economy: One person’s spending is a second person’s income, and the second person’s spending is a third person’s income, and so on.
According to this theory, recessions occur because psychological factors cause individuals to increase savings, which interrupts the circular flow of money, leading to a vicious downward cycle. When this happens, the central bank—the Federal Reserve—is supposed to increase the amount of money in the economy by lowering interest rates. Once people have more money to hold, their confidence will increase, and they’ll resume spending.
John Maynard Keynes, the father of this theory of economics, asserted that there could theoretically be a situation (he knew of no such example) in which the central bank could lower interest rates no further, as they would approach zero (known as the zero lower-bound), yet consumers would remain unwilling to spend—a condition known as a “liquidity trap.” If this were to happen, the central bank would be severely limited in its ability to spur economic activity, and government should step in to deficit spend.
Many in the economics community believe we confront this situation today: Interest rates cannot go lower, and consumer spending and business investment remain depressed.
Despite these indicators, however, there is reason to question the liquidity trap proposition.
First, the proposition itself is built on a broader framework that assumes savings interrupt the circular flow of money. But savings is simply income unused on products or services. What goes unspent does not just sit in a bank account, halting the flow of money. Savings are lent out for others to spend and invest, or at the very least invested in T-bills for government to spend, meaning that both consumption and savings continue the flow of money in the economy. Proof is in observing how hard financial markets work to earn interest on every dollar at every moment, meaning that no dollars—savings or otherwise—sit idle.
However, even if we grant that savings leaks out of the circular flow of income, would the liquidity trap be a viable explanation for our current economic malaise?
Answering yes requires one to believe that government can neatly target those savings and break the trap. But how does anyone know who will and will not lend his or her savings to the government in exchange for a T-bond? Furthermore, it requires one to suspend the normal purpose of saving.
Saving serves as a hedge against future risk and a fund for anticipated future consumption and investment. Businesses that are building up savings are protecting themselves from what they perceive as future risks (just as households are doing), not sitting on excess cash reserves for no reason. Thus, even if government could soak up those savings in order to deficit spend, it is equally soaking up the protective hedge that these businesses have amassed. So, rather than inducing more private spending, deficit spending encourages more saving, to restock the initial hedge of savings that the government depleted. In other words, any increased economic activity brought about by government deficit spending is likely offset by an increase in savings, resulting in no net new economic activity. This is known as the broken window fallacy.
A better explanation for our persistently depressed economy, then, is that loose monetary and fiscal policies have misallocated economic resources, resulting in less productive economic activity overall.
On top of that, onerous laws such as Obamacare and Dodd–Frank contain thousands of pages of new rules affecting the conduct of businesses. Many rules are still unknown; indeed, new ones are being discovered daily. How are businesses to consider expansion without clearly delineated rules for doing so? Keynes himself worried as much: “Even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action.”
The notion of a liquidity trap not only depends on a highly questionable framework regarding the role of saving in economic activity, but it also depends on suspending the normal purpose of saving, which serves individuals and businesses as a protective hedge against risk. In light of these realities, it’s difficult to make a convincing case that we’re in a liquidity trap.
A more sound explanation is that a profligate government has exhausted resources that would otherwise have been employed by the private sector, and that its continued profligacy has dumped a bucket of cold water on business activity, freezing the very free market it’s attempting to rejuvenate.