During the January ECB press conference, its president made some interesting reference to the liquidity trap which the ECB was not willing to risk going into. Important in this respect is, of course, how a liquidity trap would be defined for a central bank to be in a position to actively decide to either jump into it or to stay out.
Perhaps the easiest way to describe a liquidity trap is a situation when lower interest rates are unable to make any positive contribution to stimulating aggregate demand. A circumstance like that could be arrived at by two different routes.
First, the central bank cuts rates to the point that constitutes the “effective zero bound” of monetary policy, i.e. the point in which economic agents might in their majority decide that holding money accounts in banks or money market funds is not worthwhile and instead exchange these holdings for the asset class “put it under the pillow”.
Second, the monetary transmission mechanism is sufficiently broken so that credit demand at a given interest rate is not met by an equivalent credit supply so that the impact on aggregate demand while existent in theory is not turned into reality. That’s what you would call a “credit crunch”.
Only under the first of those two circumstances it is up to the central bank’s choosing whether it finds itself in a liquidity trap. And unless one has ever tried, it is neigh on impossible to know where the effective zero bound is located. However, if the second of the aforesaid conditions were to prevail, it is not only not for the central bank to choose but it would actually hinder the necessary dose of fiscal policy to come to the rescue. For as Sargent and Wallace taught us in the early 1980s higher key interest rates will lower the ceiling up to which government debt will be perceived as sustainable by creditors and thus limit the room for short-term fiscal expansion.
So what would constitute a proper policy course for the ECB right now, given that in most likelihood none of us knows where the effective zero bound is or whether we are in a liquidity trap?
First of all, it is important not to knock over some (further) systemically important parts of the financial system such as the money market funds by accident once you bring down key interest rates below a certain threshold. It would therefore be prudent to create the equivalent of the “Money Market Investor Funding Facility”.
Second, the ECB should continue to lower key interest rates. Whether it likes it or not, the liquidity trap might already be here. So the proper course of action is most likely to be to remove any obstacle for fiscal policy to be as effective as it possibly can be. Which means: Trichet and his colleagues should take a try at the effective zero bound.