Expect to hear more about The Liquidity Trap. Although this sounds like a bad movie or a situation when an individual reaches insolvency, it is an actual Keynesian technical term which describes a macro economic situation where people (and institutions) opt for cash over other investments options. In an investment climate when investor confidence is low, investment returns are close to zero, and the environmental risk is high, investors forgo investments and prefer to keep their money in cash. A paltry return doesn't out weight the risk, and safety of cash (or cash equivalents such as US Treasury bonds) is preferred. To some degree this is the natural and unfortunate effect of the larger deleveraging process. Whereas we might have kept too little cash on hand, now we are keeping too much cash on hand. US Businesses are estimated to be sitting on over $2 trillion in cash and cash equivalents. In theory, when interest rates are near zero, when the cost of borrowing almost free, companies should be borrowing and putting the money to work. The result is lots of inactive money sitting on the sidelines rather than being invested in the economy - a situation that was thought to be theoretical in modern economies until Japan experience a prolonged Liquidity Trap and fell into a "lost decade" at the turn of the century.

Let's examine the deleveraging aspect of the Liquidity Trap. When one is leveraged, in some cases as high as 30x to 40x, it means that both ups and downs are magnified. By borrowing money at 40x, you put up only $2.5 for every $100 you control. If the asset goes up 1.25%, you make a whopping 50% return on investment. However, a small fall of 2.5% means you are wiped out. If the investment goes down 5% and you have to put up as much money as you put down originally. In good times when confidence is high, investors rationalize being highly leveraged to maximize the return. But in bad times, these aggressive investors were completely wiped out - and many investors are still smarting from their recent wounds during the housing crisis. Banks, too, were burned. Without the proper collateral, defaults on loans meant huge write-offs. Banks have over compensated by being overly cautious in their lending standards. High lending standards have resulted in banks sitting on over $2 trillion in cash and cash equivalents. The lending standards mean only the most highly qualified can borrow and, ironically, these are also the least likely to need to borrow. Banks have $1.3 trillion of idle money parked at the Fed, giving them a return of a miserly 0.25%. Individual investors are doing the same. Low rates of return in investment opportunities often don't compensate for the risk involved - the individual finds it more attractive to retreat to the security of cash over other investment options.

Quantitative Easing, which increases the money supply, should cause inflation as more money chases the same number of goods. Rather, this excess cash is being sucked up by companies and investors. All this money is idle and not able to be used for growing the economy. In normal times, businesses would take advantage of extremely low cost loans to expand their businesses: in theory they could grow their business by a rate higher than the interest on their loan. Expansion means increasing hiring, suppliers, and ultimate paying salaries that would (in aggregate) create the customers that would buy the resulting end-products and services. But the cycle is broken.

As an example of the current situation, at the beginning of August, 2011 JP Morgan just announced that it would charge customers who hold more than $50 million in cash. Why? Bank's high lending standards means they are unable, or unwilling, to lend, so they are sitting on cash just like their depositors. Idle money can end up costing the bank, since they have to pay FDIC insurance on the assets held.

Keynes had two prescriptions to fix an economy stuck in Liquidity Trap. First, inflation or the threat of inflation can cause investors to reevaluate their position. After all, by sitting on cash earning virtually zero in interest, and with inflation causing the price of things to go up, people are faced with a dilemma: spend it now (or invest it now) to lock in the purchasing power or end up with a negative rate of return and diminished purchasing power. The danger is that with the prior increase in the money supply and the low interest rates, like a wheel getting unstuck, we may fly off into hyperinflation and everyone simultaneously attempts to put their cash to work. Secondly, the government can spend. When the government can borrow at practically no cost, it is precisely the time for it to do so. America is badly in need of infrastructure investments. Its roads, schools, communications infrastructures are quickly falling apart, causing us to lose our edge to compete for business with other nations. Government spending, also known as stimulus spending, may have kept us from falling further into recession and more would be needed to get our economy and country moving forward. But even it might be the right economic prescription for our country; it also would be political suicide for any politician to seriously suggest.

Mr. Camden R. Fine, president and chief executive of the Independent Community Bankers of America, published on August 25, 2011 a comment that was quite telling: "With nearly zero percent rates and slack credit demand, how are community banks supposed to make a viable margin on their funds? Community banks are swimming in liquidity as depositors pour their savings into their local banks in search of safety and security." His point was the Fed's zero percent interest rate is painful to small banks that rely on lending to make money, however, banks make money off the difference between the Fed Rate and their borrowing rate. Banks can borrow from the Fed at almost zero, and are advertising a 30-year mortgage at 4.5%. If the Fed Rate was 4.5%, banks could make the same money by lending at 9%. The more interesting point is that banks of all sizes, reacting to the loose lending standards, are very reluctant to lend. There are businesses and individuals out there that would borrow at these low rates and use it to purchase or refinance a home or invest in expansion of a business, but it is more difficult than ever to borrow. Combine that with uncertain economic times, where businesses and individuals are scared to invest at all, preferring the safety and security of cash. So we have the twin problem of a dysfunctional banking system that isn't lending and individuals and companies that are hoarding cash.

Not everyone has bought into the concept that we are stuck in a Liquidity Trap. For example, the Fed has said it will keep the Fed Rate (the rate at which banks borrow) at almost zero for the next two years. In addition, there is some speaking of another round of Quantitative Easing (a so called QE III). If we are in a Liquidity Trap, these would be precisely the wrong prescription to the problem. But we believe that you will increasingly hear economists call for some inflation. Here at The-Party-of-Common-Sense.org we believe inflation (or the threat of inflation) maybe just what is needed to nurse our ailing economy back to health.