How to get out of the "liquidity trap"?

97 per cent of advanced economies have interest rates below 1 per cent

On 5 November 2020, two days after the US election and as the Covid-19 pandemic is not over, IMF Chief Economist Gita Gopinath warned us that the global economy had entered a “liquidity trap”. A “liquidity trap” in economics is a situation where monetary policy has limited to no effects as interest rates have fallen so low that agents prefer to hold liquidity to any form of debt.

Indeed, as she noticed, “in 60 per cent of the world economy, and, among them, in 97 per cent of advanced economies, central banks have reduced interest rates below 1 per cent”. In 20% of the world, rates are even actually negative.

Monetary policy tools have been exhausted

In Australia on 3rd November 2020, the RBA reduced the cash rate to an all-time low of 0.1 per cent and launched a AU$100 billion “quantitative easing” program in a further effort to inject liquidities in the Australian economy and to reduce the value of the Australian dollar to boost exports. However, the Australian dollar has appreciated by 4% against the USD and most currencies since as there is a currency war and it hurts domestic producers, already feeling the hit of the trade war with China.

Hence traditional as well as innovative monetary policy tools have been exhausted and central banks seem powerless to manage further their economies.

So, how do we get out of this situation?

Why raising interest rates would make things worse

Some advocate raising interest rates as an increase in short-term interest rates would encourage people to deposit and invest their cash, instead of hoarding it. Higher long-term interest rates would encourage banks to lend since they would get a higher return. That would also increase the velocity of money.

However, there would be negative effects to an even small increase in the interest rates as homeowners with mortgages and businesses with corporate loans would face it hard to pay more in a recessionary situation and this would only make matters worse and precipitate more foreclosures and bankruptcies. It would also hurt public budgets as it would increase the burden of debt cost.

Why letting prices fall enough would be dangerous

Another idea put forward by some would be to let prices drop to such a low level where an equilibrium would be reached, and people could not resist buying any more as they would perceive the rewards are so high that they would exceed the risks.

This would be an even more dangerous idea than raising interest rates as there would be a lot of collateral damages to a free fall of prices and once the downward price spiral has started, it would be extremely difficult to stop it and reverse it.

Others have mentioned ideas about financial innovation and global rebalancing but financial innovation with the creation of new attractive financial assets such as derivatives would only concern a small part of the economy and not solve the whole problem. As for global rebalancing – i.e., a concerted rebalancing between countries who experience liquidity trap and whose who do not – it is hard to envisage it in a time where multilateralism is vanishing, and countries are only considering their own interests. And anyway, most of the world is in liquidity trap so there would not be much rebalancing to do.

Expansionary fiscal policy should take over from monetary policy

The only effective solution in fact would be for the fiscal policy to take over from the monetary policy and that is the solution put forward by the IMF Chief Economist as she said, “governments should use their spending power to re-energise demand on a global scale”.

Some would object that governments over the world have already spent a lot to address the Covid-19 crisis and blew up their debt to GDP ratio: Australia’s public debt to GDP has jumped from 42% to 53%, France from 98% to 118%, US from 106% to 123%. Even frugal Germany’s decade-long trend to reduce their public debt had to be interrupted as its debt ratio to GDP went from 57% in 2019 to 71% at the end of 2020 as it had the most generous emergency aid package. All developed countries seem to have added about 20% of public debt just to save their economy from falling because of the Covid-19 lockdown and business halt, so it is hard to imagine more is needed.

However, the effects on the economy – and on human lives – would have been much worse without these rescue packages, as bankruptcies in chain would have caused tens of millions to lose their jobs and triggered an economy recession much worse than the Great Depression of 1929.

It makes economic sense to borrow in these times

Besides, in a time of record-low – and even negative – interest rates, fiscal prudence is more complicated than it used to be, and it actually makes sense in a budgetary point of view to borrow.

And there is no shortage of areas where public investment is needed and would make a big difference: health, infrastructures, and above all environment protection and fight against climate change. As Gita Gopinath said, “these expenditures create jobs, stimulate private investment and lay the foundation for a stronger and greener recovery”.

Former governor of the Bank of England Mervyn King is further considering that “the world’s advanced economies have been stuck in a ‘low growth trap’ for at least a decade”, that policymakers were “clinging to a particular model of monetary policy which is leading them to misdiagnose our current economic problems”. Indeed, most of these policymakers are conservative or neoclassical trained in years where the priority was to curb inflation (the 1970s and the 1980s) and balance budgets. Now, the danger is not inflation but deflation and borrowing at negative interest rates makes more sense than paying off debts as the global economy is suffering from a sustained lack of demand.

As a matter of fact, economics teaches us that when the real interest rate is less than the rate of economic growth, the existing stock of debt is reduced over time in relation to the economy as a whole, so it doesn’t have to be financed by increased taxes in the future. Furthermore, there is no “crowding out effect” of public investment on private investment in the current situation as interest rates are not driving up borrowing costs for households and firms as they would in classical situations.

For Larry Summers, former US Treasury secretary, “the fundamental issue is to assure that global demand is sufficient and reasonably distributed across countries”.

Ambitious expansionary fiscal policy plans will achieve a double objective

US President-elect Joe Biden, together with Janet Yellen, former governor of the Federal Reserve and his pick for Treasury secretary, is planning a $1 to 1.5 trillion stimulus package and $5.4 trillion over the next decade on social, education, development and environmental programs.

Likewise, Ursula von der Leyen, President of the EU Commission, has set up a $891 billion stimulus

package and wants to raise 30% of it in green bonds earmarked for projects related to mitigating climate change and the environment such as developing railways and renewable energies. This is the right way to go as scientists tell us that the cost of doing nothing would be much worse than of acting now. Unfortunately, her actions are not enough relayed by conservative governments such as Macron’s France and the rich Stingy Four who are reluctant to spend more.

Australia is particularly absent in this movement, paradoxically as its debt ratio would afford it to do so as it is in the lowest among developed countries, and, even worse, it is still clinging to coal mines and gas plants.

Thus, an ambitious fiscal program is the best solution for all advanced economies hardly hit by the Covid-19 pandemic and its economic consequences, as it will achieve a double objective:

1. getting us out of the liquidity trap by injecting money in the economy where it is needed, which will create moderate inflationary pressures and ward off the spectre of deflation;

2. preparing the future by planning for future disasters and mitigating climate change.