What is a liquidity trap?

A liquidity trap is an economic situation characterised by low-interest rates and high savings, where a negative sentiment causes people and businesses to hang on to their money resulting in a lack of investment. 

Central bank policies that aim to stimulate spending and economic activity struggle to make an impact during such periods. Negative market and consumer confidence is the hallmark of a liquidity trap. Investors avoid buying bonds during a liquidity trap due to the prevailing beliefs that interest rates could soon rise. 

Why does a liquidity trap occur? This article looks at the liquidity trap meaning and describes how they happen.

Low-interest rates and a lack of faith in the economy are the catalysts for liquidity traps. The Bank for International Settlements (BIS) defines liquidity traps as being synonymous with ineffective monetary policy. 

Interest rate cuts are the primary tool of central banks to stimulate growth in an economy. They work by lowering the cost of borrowing, which encourages people to take on credit and spend more. Businesses start to invest and hire more staff while individuals consume more, resulting in the economy's overall growth.

According to the BIS, the problem with this approach comes when prevailing interest rates are already near their “effective lowest bound”. Once rates are hovering close to zero, central banks can no longer cut rates to spur economic activity. 

Moreover, an underlying pessimistic view of the economy could render an interest rate cut ineffective in spurring lending, investment and consumption. Low public confidence in central bank policies and economic growth is key to forming a liquidity trap. For this reason, this type of economic situation often occurs during or after a severe recession. 

What causes liquidity traps?  

To understand the topic better, let's look at a liquidity trap example.

From 1991 to the early 2000s, Japan experienced a period of economic stagnation commonly referred to as the “Lost Decade”.

Following the end of World War 2, Japan emerged as a leading economy. At one point in the 1980s, it had the world’s highest gross national product per capita. The island nation witnessed soaring stock market valuations and real estate prices as it implemented loose monetary policies to fuel growth. The asset bubble burst at the start of the 1990s, however, as Japan embarked on a rate-hike cycle to cool down its red-hot real estate sector. This reversal of monetary policies sent Japan’s stock market into a downwards spiral and dragged its economy into a debt crisis.

Shattered consumer confidence caused households to save more. By the time Japan’s central bank tried to enact a liquidity trap solution by cutting interest rates, it was too late. The bank’s pivot wasn’t enough to pull Japan out of the liquidity trap. 

Japan’s economy has still not recovered fully from the Lost Decade. The country is still suffering from low wage growth, and its equity benchmark Nikkei 225 index (J225) has not yet topped the highs it witnessed over three decades ago. The Nikkei 225 Index’s last all-time high was recorded on 29 December 1989, when it reached 38,957.44 points.