Reply To: Liquidity trap


The liquidity trap is the claim made by J.M. Keynes to explain why private investment cannot be relied upon to restore an economy in depression, even if the central bank lowers interest rates. Keynes asserted that interest rates can fall to a level at which all investors form the expectation that they will rise in the near future, in which case investors will hold cash and wait until rates rise to invest.

There are two main points against Keynes. First, the interest rate is not merely the rate on credit. Instead, the interest rate is the rate of return on all investments of any type. There’s no reason to think that if the central bank has pushed credit rates down that investment in production cannot still command a rate of return.

Second, the reason investors hold cash during depressions is the greater uncertainty about returns on production. Financial collapses can impair entrepreneurs’ confidence in their abilities to anticipate what will be and will not be profitable. Moreover, government policy behavior can induce “regime uncertainty” among entrepreneurs, a condition in which they hold money to wait and see what the political regime will be once the unpredictable policy behavior of the government subsides.