Why The IMF Is Wrong About Liquidity Traps

In the Financial Times from November 2, 2020, the International Monetary Fund chief economist Gita Gopinath suggested that world economies at present are likely to be in a global liquidity trap. Gopinath has reached this conclusion because the yearly growth rate of the price indexes has been trending down despite very low interest rates policies. According to the IMF chief economist, central banks have lowered interest rates to below 1 percent and in some countries interest rates are at present negative. In the framework of a liquidity trap, it is held that the ability of central banks to stage an effective defense against various economic shocks weakens significantly. So how can one resolve the problem of the central banks' inability to produce the necessary defense of the economy?

A possible way out of the liquidity trap, suggests Gopinath, is to employ aggressive loose fiscal policy. This means aggressive government spending in order to boost the aggregate demand.

According to Gopinath,

Fiscal authorities can actively support demand through cash transfers to support consumption and large-scale investment in medical facilities, digital infrastructure and environment protection. These expenditures create jobs, stimulate private investment and lay the foundation for a stronger and greener recovery. Governments should look for high-quality projects, while strengthening public investment management to ensure that projects are competitively selected and resources are not lost to inefficiencies.

Furthermore, according to Gopinath,

The importance of fiscal stimulus has probably never been greater because the spending multiplier—the pay-off in economic growth from an increase in public investment—is much larger in a prolonged liquidity trap. For the many countries that find themselves at the effective lower bound of interest rates, fiscal stimulus is not just economically sound policy but also the fiscally responsible thing to do.

What exactly is the liquidity trap that the IMF chief economist is warning us about?

The Liquidity Trap: What Is It All About?

This popular framework of thinking originates from the writings of John Maynard Keynes, where economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual's earnings.

Recessions, according to Keynes, are a response to the fact that consumers—for some psychological reasons—have decided to cut down on their expenditure and raise their savings. For instance, if for some reason people become less confident regarding the future, they will cut back their outlays and hoard more money. Therefore, once an individual spends less, this will worsen the situation of some other individual, who in turn will also cut his spending. A vicious circle sets in—the decline in people's confidence causes them to spend less and to hoard more money. This lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the growth rate of money supply and aggressively lower interest rates. Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby re-establishing the circular flow of money, so it is held.

In his writings, Keynes suggested that a situation could emerge where an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further. As a result, the central bank would not be able to revive the economy. This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that interest rates should subsequently rise, leading to capital losses on bond holdings. As a result, people's demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply. As a result, this is going to undermine the circular flow of money and the economy will plunge into an economic slump. On this Keynes wrote,

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