A liquidity trap is a situation when people are hoarding cash, this out of various reasons. A standard definition would say because people are expecting an adverse event, such as deflation, insufficient aggregate demand or war. The classic debate between Keynesians and Austrians focus on the “why”, not the fact that cash hoarding occurs. For Keynesians it’s all about liquidity preference, for Austrians rather time preference. Now are we liquidity trapped ?
When looking at the balance sheets of major central banks world-wide and after their major efforts in terms of quantitative easing – which basically liberates money from bank balance sheets – it seems we are. But may be not in the traditional definition sense of the word. Last week, the ECB released new numbers on financial institutions’ use of ECD deposit facilities :
Some 453 bio EUR has been parked, a new record amount and equivalent to something roughly the size of almost 1.5 times Belgian annual GDP (!). An enormous amount of potential creative money, effectively put to sleep. Why and where does it come from ? And it is not restricted to the ECB, in the US we see similar trends of financial institutions parking new fresh printed money through QE in the safe hands of the FED. Return to sender.
In the case of the US, it might well be that banks are doing this out of various reasons. Primo, private sector deleveraging is in full progress, also proven by consumer credit numbers and monthly declines of overall consumer credit outstanding. The consumer is cleaning up his balance sheet and is further handicaped by the fact that asset prices are going down (Housing no longer the ATM machine for Joe 6-pack). More generally speaking, banks on the other hand have moved into a more stricter regulatory environment with more stricter lending standards prevailing : less money made available to potential private sector borrowers. Let’s call it credit rationing and hopefully the screening procedure works, meaning that those entitled to some kind of financial support for productive objectives still can rely on the money.
But there are other factors at work as well. And it involves banks under various angles. Counter party risk is still very much alive so interbank lending no longer exists. Basically, banks park money at the intermediate lender of the last resort (central bank) and the central bank tries to fulfill the transmission mechanism. But the transmission then stops, it doesn’t seem to filter into the private sector. And it’s not restricted to banks, a lot of companies (Siemens etc) have used their legal status of financial company in order to open up an account at the central bank. So a complete absence of trust is co-responsible for money being put to sleep.
Over the last couple of weeks, we had some major LTRO operations like the ECB 150 bio pre-financing of European banks (bank bonds coming at maturity 2012/2013) with a 36 month horizon. It will be interesting to watch how these facilities at the ECB therefore further evolve. In February a new auction is scheduled which will bring the estimated amount to over 300 bio EUR. How will banks use this money ? Is it in fact for paying off debt and profiting from a cheap ECB funding rate in the medium term ? We will soon find out but in the mean time, we don’t see a lot of creative things being done with fiat money. That is, if you still can call it “fiat” money…