What Happens When Cutting Rates Stops Working? Money That Sits Still

A liquidity trap is a condition in which the interest rate has fallen so low that reducing it further does nothing to increase borrowing, spending or investment, so the central bank's main instrument stops working. The usual mechanism is that cheaper borrowing encourages firms to invest and households to spend, and that mechanism fails when rates are already near zero and expectations are pessimistic, because additional money supplied to the economy is simply held rather than lent or spent. The idea was introduced by Keynes in the 1930s and was treated for decades afterwards as a theoretical curiosity that would not occur in practice, which turned out to be wrong.

Several things bound how far rates can fall and each has been tested:

• •Physical cash pays zero interest and can be held, so nobody accepts a sufficiently negative return
• •Storing and insuring large quantities of cash costs something, which allows mildly negative rates
• •Several central banks did set slightly negative policy rates after 2014, which worked in a limited way
• •Banks were reluctant to pass negative rates to retail depositors, which blunted the effect
• •Persistent negative rates squeeze bank profitability, which can reduce lending rather than increase it
• •The practical floor is somewhat below zero rather than exactly at it

The policy response developed a set of tools that were unconventional when introduced and are now standard. Quantitative easing involves the central bank buying long-term assets with newly created reserves, which lowers long-term rates directly rather than through the short-term policy rate and pushes investors towards riskier assets. Forward guidance commits the bank to keeping rates low for a stated period or until a stated condition is met, which works on expectations, since long rates reflect expected future short rates. Yield curve control targets a particular long-term rate directly. Credit easing buys private assets to reduce specific spreads. Assessments of effectiveness vary and the consensus is that these tools did something measurable and less than conventional rate cuts would have done at the same scale.

The Japanese experience from the early 1990s was the first modern case and shaped everything that followed. An enormous asset price collapse left banks holding bad loans and firms concentrating on repaying debt rather than investing, which reduced demand regardless of how cheap borrowing became. Rates were cut to near zero by 1999 and stayed there, mild deflation set in and persisted, and growth remained weak for two decades. Policy responses including large public works programmes and the first use of asset purchases were tried and assessed at length. The episode was studied closely by economists who later held senior central banking positions elsewhere, and the lessons drawn from it, particularly about acting early and about the danger of allowing deflationary expectations to settle, shaped the far more aggressive responses adopted after 2008.

The theoretical case for government spending is strongest precisely in this situation, which is why the argument reappeared after 2008. When rates are at their floor, increased government borrowing does not push rates up and therefore does not crowd out private investment in the usual way, so the multiplier on spending is larger than in normal conditions, a conclusion supported by a considerable body of empirical work. The counterarguments concern debt sustainability, the difficulty of spending well and quickly, and the risk that measures introduced as temporary become permanent. The actual policy response in most countries after 2008 involved a period of fiscal expansion followed by consolidation, and the subsequent debate about whether the consolidation was premature is among the most contested questions in the field.

When rates approach zero and expectations are pessimistic, additional money is held rather than spent, so the central bank's main instrument stops working. Cash pays zero and can be stored, which puts a floor slightly below zero rather than exactly at it. Asset purchases and commitments about future rates were the substitutes, and the case for government spending is strongest in exactly this condition.