How a liquidity trap stalls the economy

HostMost of us think that when it's cheap to borrow money, people will run out and buy stuff or start new businesses. It's like a big sale at a store. If the price of a loan drops to almost nothing, you would think the whole world would be lining up to take one.

HostBut there are times when even if the bank says you can have money for basically zero cost, nobody wants it. Why does the engine just stop like that?

GuestIt's a bit like a car engine that has been flooded. You keep pumping the gas, but the car just sits there and coughs. In a normal world, the people who run the money—the folks at the central bank—lower the cost of borrowing to get things moving. They want you to buy a new house or grow your shop. They lower those interest rates so that keeping your money in a savings account feels boring because it earns nothing. They want you to get that money out and spend it. But when you hit a liquidity trap, that tool just breaks. People start to feel like holding onto cash is the only safe move. Even if the rate is zero, they would rather keep their cash under the mattress than do anything with it. The money is there, it's free to use, but it just stays still.

HostThat doesn't seem to make sense. If the money is free, why not take it? Even if you're a little worried about the future, zero percent is zero percent. You're not losing anything by taking the loan to try and build something.

GuestYou have to look at what people think is coming next. If you think the whole system might crash, or if you think the prices of things like cars and houses are going to drop next year, having cash in your hand is actually better than owning a house that's losing value. There's also a bit of a floor problem. If interest rates are already at zero, they can’t really go much lower. So, everyone starts to think that the only way for rates to go in the future is up. If you think rates will go up soon, you don't want to lock yourself into a deal now. You wait. You sit on your cash and wait for the world to change. When everyone waits at the same time, the whole economy just stalls out.

HostIt sounds like trying to lead a horse to water but the horse has decided it's never going to be thirsty again. But if the money is just sitting in bank vaults, why not just print even more of it? If the government flooded the streets with cash, wouldn't people eventually have to spend it?

GuestThat's what people used to think, but in a trap, it's like pouring water into a bucket with no bottom. The water doesn't stay in the bucket to help the garden grow; it just drains away. In this case, it drains into people’s savings. They call this pushing on a string. You can pull a string and move something behind it—that's like raising rates to slow things down. But when you try to push a string to make the economy go faster? The string just bunches up in your hand. No matter how much money you pump into the banks, if the banks are too scared to lend and the families are too scared to spend, that new money just sits there. It does nothing to help create jobs or sell goods.

HostThis feels like a bit of a nightmare. If the usual tricks with interest rates don't work and printing more money doesn't help, are we just stuck in the mud forever?

GuestNot forever, but we have to change the way we fight it. Since the people who manage the interest rates are out of moves, someone else has to step in. Usually, this means the government has to stop worrying about the banks and start spending money directly on things we can see and touch. They have to build bridges, fix roads, or hire people for public work. They have to put cash right into the hands of people who are so broke they have no choice but to spend it on food or rent. They have to jump-start the heart of the economy because the brain—the central bank—can't get the signal through anymore. You have to create the demand yourself because the people are too frozen to do it on their own.

HostSo the very thing that helps one person survive—saving every penny they have—actually ends up hurting everyone else when the whole country does it at once.

GuestThe biggest danger is that once people get used to the idea that things will never grow, they stop trying to grow them, which makes the trap even deeper.

HostThat cheap money we expect to solve our problems ends up being a sign that the road ahead is completely blocked.