From the Financial Times' FT Alphaville blog:
Ah, the elusive liquidity trap. Does it exist? Is it here? And what does it mean for monetary policy?From a long time ago (the tune, not the performance):
Those are critical questions which are not currently being addressed by policymakers, according to a new paper by Paul McCulley and Zoltan Pozsar, presented at the Banque of France on March 26. In fact, many policymakers, they say, are still under the mistaken belief that no such thing as a liquidity trap exists.
So what counts as a liquidity trap?
The authors see it as the following:
A liquidity trap is a circumstance in which the private sector is deleveraging in the wake of enduring negative animal spirits caused by the bursting of joint asset price and credit bubbles that leave private sector balance sheets severely damaged. In a liquidity trap the animal spirits of the private sector cannot be revived by a reduction in short-term interest rates because there is no demand for credit. This effectively means that conventional monetary policy does not work in a liquidity trap.The point here is that conventional monetary policy cannot work because the economy’s demand for credit is saturated. In a liquidity trap, the transmission mechanism becomes broken.
The other point the authors hint at strongly is that central bankers like Ben Bernanke are accutely aware of this fact — and you just have to read Bernanke’s 2003 paper on Japan’s deflation to understand that. The reason central bankers will never admit it...MORE