Why The IMF Is Wrong About Liquidity Traps – Analysis


By Frank Shostak*

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 reestablishing 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,

There is the possibility…that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.1

Once an economy is seen to be weakening in the midst of a policy of very low interest rates, most economists regard this as a sign that it has fallen into a liquidity trap. Once this happens, if some other policies are not introduced, it is held that the economy is doomed to be stuck in a stage of permanent stagnation. To prevent this from happening it is recommended that authorities embrace an aggressive fiscal policy stance. This means that the government should step in and spend aggressively. The spending can be on all sorts of projects. Because of this spending, it is held, the consumer confidence is going to strengthen. With a higher level of confidence, consumers will lower their savings and raise their expenditure.

Does Monetary Expenditure Cause Economic Growth

In the Keynesian framework, the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this implies they save less. Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed as saving more. In this way of thinking, saving is considered bad news for the economy—the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)

Observe however, that people do not pay with money, as suggested by the Keynesian framework, but rather with the goods that they have produced. The chief role of money is as a medium of exchange. Hence, the demand for goods is constrained by the production of goods, not by the amount of money spent. (The role of money is to facilitate the exchange of goods.)

Paraphrasing Jean-Baptiste Say, Mises wrote,

Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.2

To suggest that people could have an almost unlimited demand for money that supposedly leads to a liquidity trap would mean that people do not exchange money for goods any longer. Obviously, this is not a realistic proposition given the fact that people require goods to live. People demand money not in order to accumulate it, but to employ in exchange. Being the medium of exchange, money can only assist in the exchange of one producer’s goods for another producer’s goods.

Real Saving Is the Heart of Economic Growth

Various tools and machinery, or the infrastructure that people have established, is for only one purpose and it is to be able to produce the final consumer goods that are required to maintain and promote people’s lives and well-being. The quantity and quality of various tools and machinery determines the quantity and quality of final consumer goods. With more and better capital goods, i.e., tools and machinery, the workers’ ability to produce more goods and of an improved quality is likely to increase. What permits the expansion of capital goods is real savings, which is the amount of consumer goods produced less the consumption of these goods by their owners. Note that real savings sustain the various individuals who are engaged in the various stages of production.

The greater the production of consumer goods, all other things being equal, the larger the pool of saved consumer goods, i.e., the pool of real savings, is going to be. A larger pool of real savings can now sustain more individuals employed to enhance and expand the infrastructure. This of course means that through the increase in real savings, a better infrastructure can be built, which in turn sets the platform for a higher economic growth.

Higher economic growth means a larger quantity of final consumer goods, which in turn permits more savings and more consumption. With more savings, a more advanced infrastructure can be generated, and this in turn sets the platform for a further strengthening of economic growth.

Note that the savers here are wealth generators. It is wealth generators who save and employ their real savings in the buildup of the infrastructure. The savings of wealth generators are employed to sustain various individuals who specialize in the making and the maintenance of the infrastructure. (Real savings also sustain individuals who are engaged in the production of final consumer goods).

According to Mises,

The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way.3

Now is it valid to argue that the expanding monetary flow supports economic growth? If this were the case, then most third world economies would have eliminated poverty by now through printing large quantities of money.

Any attempt to grow an economy by means of monetary pumping results in the diversion of real savings from wealth generators to wealth consumers. It results in the depletion of the pool of real savings. This in turn undermines the process of real wealth generation.

Can Government Really Grow an Economy?

The IMF chief economist’s notion that the government can grow an economy originates in idea of the Keynesian multiplier, in which an increase in government outlays gives rise to the economy’s output by a multiple of the initial government increase.4

But in similarity to loose monetary policy, loose fiscal policy sets in motion a diversion of real savings from wealth-generating activities to government-supported activities.

To support the increase in government outlays, government has to divert real savings from the private sector of the economy. This means that wealth producers in the private sector are going to part with their real savings to support individuals who are employed in various government projects that are likely to be lower on individuals’ priority lists. This in turn weakens the production of wealth and, all other things being equal, weakens the pool of real savings.

It follows, then, that not only does the increase in government outlays fail to raise overall output by a positive multiple, but on the contrary it will result in the weakening of the process of wealth generation in general.

By boosting consumption while weakening the process of real wealth generation, loose fiscal policies undermine the pool of real savings.

According to Mises,

there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.5

Liquidity Trap and the Shrinking Pool of Real Savings

As long as the growth of the pool of real savings stays positive, it can continue to sustain productive and nonproductive activities. Trouble erupts when a structure of production emerges that ties up much more consumer goods than it releases as a result of continuous loose monetary and fiscal policies over time. (The consumption of final consumer goods exceeds the production of these goods.)

The excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings. As a result, fewer activities can be now introduced. This results in the economy plunging into a slump.

Once the economy falls into a recession due to the falling pool of real savings, any government or central bank attempt to revive it is going to fail. Not only will these attempts fail to revive the economy, they will deplete the pool of real savings further, thereby prolonging the economic slump.

The shrinking pool of real savings exposes the erroneous nature of the commonly accepted view that loose monetary and fiscal policies can grow an economy. The fact that central bank policies become ineffective is not due to the liquidity trap, but because of the decline in the pool of real savings. In the framework of a declining pool of real savings, fiscal policies will also be ineffective. But the policy ineffectiveness is always present whenever central authorities are attempting to “grow an economy.” The only reason why it appears that these policies “work” is because the pool of real savings is still expanding.


Contrary to the popular thinking, if world economies were to fall into a liquidity trap, i.e., monetary policy ineffectiveness, the key reason for this would not be a sharp increase in the demand for money, but the depleted pool of real savings. Major contributing factors to this depletion are previous loose monetary and fiscal policies.

The IMF chief economist’s recommendation to counter the so-called liquidity trap by boosting fiscal spending will only make things much worse through a further depletion of the pool of real savings. What is required to revive world economic growth is to provide businesses with a free environment for growth. For this to occur, all the loopholes for the generation of money out of “thin air” must be closed and government outlays must be cut to the bone. In addition, the various regulations on businesses, which undermine their ability to generate real wealth, must be removed. Again, the key to economic prosperity is the generation of an abundance of real wealth. Only businesses—not government bureaucrats—are capable of achieving this.

  • 1.John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: MacMillan and Co. Ltd., 1964), p. 207.
  • 2.Ludwig von Mises, “Lord Keynes and Say’s Law,” in The Critics of Keynesian Economics, ed. Henry Hazlitt (Lanham, MD: University Press of America 1983), p. 316.
  • 3.Ludwig von Mises, Human Action: A Treatise on Economics, 3d rev. ed. (Chicago: Contemporary Books), p. 490.
  • 4.Keynes, The General Theory, p. 129.
  • 5.Mises, Human Action, p. 744.

*About the author: Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Source: This article was published by the MISES Institute


The Mises Institute, founded in 1982, teaches the scholarship of Austrian economics, freedom, and peace. The liberal intellectual tradition of Ludwig von Mises (1881-1973) and Murray N. Rothbard (1926-1995) guides us. Accordingly, the Mises Institute seeks a profound and radical shift in the intellectual climate: away from statism and toward a private property order. The Mises Institute encourages critical historical research, and stands against political correctness.

Leave a Reply

Your email address will not be published. Required fields are marked *