The Liquidity Trap

In the last few years, you may have heard that one of the problems of our economy is that banks are not loaning money, commercial loans are very hard to procure and  only very well qualified borrowers are able to obtain mortgage loans.  All of those things are true.  At the same time, interest rates and the cost of borrowing are at record low rates.    Rates that banks pay on certificates of deposit and money market accounts are so low that income on these accounts is hardly noticeable when a monthly statement arrives. 

 Lower costs of borrowing traditionally have been good economic news.  When businesses pay lower interest rates on commercial loans and consumers are charged less for mortgage loans, it sounds like great news.   However, there is a big problem with very low interest rates.  That problem lies with incentives to invest and incentives for banks and other lending institutions to make loans.  The economic term for this phenomena is referred to as the liquidity trap and it is a factor which is stifling our economy at the current time. 

 People who have cash to invest see no real reason to deposit their funds in a bank which will pay less than 1% per year.  Banks may have some cash to lend, but they choose not to because they hate to commit to a long term loan at very low rates.  Their lending power is also affected because their deposits on hand are lower. 

 Hence, the liquidity trap described above keeps funds on the sidelines and not helping to stimulate our economy.  When funds are in existence but not circulating, tax receipts by the US treasury decline.  When tax receipts decline, our “spend and spend more government” has to either cut spending, sell treasury bonds at higher than prevailing rates, or raise income taxes. 
 Throughout the election cycle we heard constant references to raising taxes on the rich or high income taxpayers to help solve economic woes.   This sounds simple and correct.  Just make the wealthy pay more;  since they are rich they won’t miss the money, the treasury will collect more and our deficit problem will begin to solve itself. 

 Here comes the second big problem.  Raising taxes on the wealthy does not automatically mean that they will pay more in taxes.  Politicians have a very difficult time understanding this concept.  I do not know how many pages are in the tax code.  It is long because of tax breaks and methods to shelter income.  The rich have the ability to use these options to their advantage because cash is king when a liquidity trap situation exists.  For example, at the current time, provisions exist for accelerated write-offs for expensive automobiles and heavy duty trucks.  Purchase of such an auto or truck may be easy for a very high income business owner and be a method to offset any hike in tax rates for such a taxpayer.  There are hundreds of examples of methods which are easy for tax avoidance for the wealthy and high income. 

 Another effect of very low interest rates is that high wealth investors turn to stocks which pay high dividends,  Most “blue chip” stocks that pay high dividends which qualify for special tax treatment.  Again, this is a perfect example of a method for high income taxpayers to avoid the effect of higher tax rates  

 Conclusion and point of this writing is the following:  Because of the Liquidity Trap, very low interest rates such as those offered at the present time, can be very detrimental to our economy.