What is a liquidity trap, and how scared of it should we be?

A liquidity trap sounds as if it should look something like the quicksand pit that a group of unwary travelers stumbles into while on safari. I haven't been prancing through any marshes recently, so when I read economist and Nobel laureate Paul Krugman chant, for the "1.6 trillionth time," that we're all stuck in one, I was a little confused.

As it turns out, a liquidity trap doesn't look like much of anything. It's a scenario in which a central bank—like the Federal Reserve—is unable to stimulate the economy by easing access to currency.

It's not good when this happens. After all, in addition to printing greenbacks, the Fed is responsible for monitoring and manipulating the economy more broadly. It was founded in the 1913 Federal Reserve Act "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In other words, its job is to make sure everyone in the country has a job and keeps earning, spending, and investing.

Sounds like a tall order, doesn't it? The Fed aims to achieve the above goals through a complex matrix of activities that includes regulating and loaning cash to banks, engineering interest rates on short-term loans between banks, and investing in bond markets. Despite their intricacies, however, the Fed's policies usually boil down to either increasing or decreasing the amount of money that's available to the economy as a whole by increasing or decreasing the amount of money that's available to banks. More money to banks leads to more loans to businesses and consumers. That leads to more jobs and more spending and more money in banks. That leads to more loans and more jobs ...

But in a liquidity trap, the Fed's usual measures won't be able to get the economy going again. It's a little bit like flooding an old car engine; simply stepping on the gas not only doesn't work, it can make the situation worse. During the mid- to late 1930s in the United States, the Fed's expansive monetary policy didn't shift the economy into gear, argues Krugman. And in the 1990s, Japan's central bank also pumped cash into the nation's troubled financial institutions, but the "more money, fewer problems" approach couldn't fuel the nation's escape from a decade-long recession. (Typically, other economists vehemently disagree.)

How does a liquidity trap come about—and are we experiencing one now? It's regular practice for banks to borrow money from the government (and from one another), then loan it out at a higher interest rate to make a profit. In a recession, the Fed typically pushes interest rates for banks lower—effectively cheapening the cost of borrowing money—so that private financial institutions are able to spread the wealth to other sectors of the economy.