Yup, we are stuck in a liquidity trap.

Month after month, there are always a few stats that remind us how the US Economy has been affected by the current recession. Some say we are out of it (you can play around with numbers as you wish, right?) but in reality, the unemployment rate is very high, the housing market is still shaky and consumers’ confidence is wavering like a mobile home facing Big Earl.

What is a Liquidity Trap?

A liquidity trap happens when there is a recession caused by a credit crunch. At first, banks will restrain their credit policies because they are having a hard time keeping their head above water. While consumers can’t really borrow more since banks won’t grant the credit, they also tend on the other hand to save more money and pay off their debt since they are afraid of losing their jobs. Then, on their side, corporations keep a high level of liquidity because they are not convinced that the economy will bounce back right away and they certainly don’t want their banker phoning to call back a loan (remember Lehman’s story anyone?).

Therefore, the whole economy is stalled because:

– Banks don’t lend money

– Consumers don’t spend money

– Companies don’t invest money.

In a few words; a liquidity trap happens when everybody keeps their money in their pocket.

How to get out of a liquidity trap? How will the US economy bounce back?

The usual method is to drop the interest rate in order to encourage consumers to borrow and corporations to invest. However, having rates at 0%-0.25% makes it difficult to drop them lower ;-). Now, the Fed has to consider other options:

2011 Stimulus Check

Offering stimulus checks in 2011 could be an option to invite people to spend this money in the economy. However, if consumers use this money to pay off their debts or to build an emergency fund (top options that really makes sense), the stimulus check would not help the economy and leave it in the liquidity trap.

Buy back bonds

Another way to inject more money in the economy would be for the FED to buy back Government bonds. This would inject more money into the market and hopefully toss away the liquidity trap. This measure is currently considered by the FED.

Wait…

Yeah, that sounds like a pretty lazy way to take care of a problem, isn’t? In fact, the US Gov’t injected a lot of money through their bailout program, 2010 stimulus checks and they smothered the credit conditions throughout their rate policy.  Therefore, the FED is well aware that they are stuck in a liquidity trap and they applied a lot of measures to get out of it. Yet, one solution is to wait and let these strategies slowly take the economy to the track of growth again. Slowly but surely, the confidence in our economy will be reinstated and the problem can be solved.  The question is: with mid-term elections coming, will the Gov’t be patient?

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