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

In the present recession, for example, the "discount rate," the cost at which banks can borrow money directly from the Fed, is set at 0.50 percent. The "federal funds rate," the target the Fed sets for banks making one-day cash loans to one another to meet capital reserve requirements, is set at 0.25 percent. According to the conventional wisdom of monetary policy, such cheap credit should get cash flowing and counteract the effects of the recession. In other words, the Fed lowers interest rates and scoops up bonds to try to counteract a dearth of lending, commonly referred to as a credit crunch.

The only trouble is that in the present crisis it's not working. Interest rates are practically at 0 percent, and the Fed has pumped jaw-dropping sums of cash into the market. In addition to the $700 billion TARP allocation granted to the Treasury by Congress (much of which has been committed to the financial sector), "the Federal Reserve Board has expanded its balance sheet by more than $1.5 trillion in loans and purchases of government-sponsored enterprise securities," according to a Congressional Oversight Panel report assessing the first six months of financial rescue efforts. In fact, "The total value of all direct spending, loans and guarantees provided to date [as of April 7, 2009] in conjunction with the federal government's financial stability efforts (including those of the Federal Deposit Insurance Corporation (FDIC) as well as Treasury and the Federal Reserve Board) now exceeds $4 trillion," according to the same report.

Such vast disbursements are made possible by the Fed's ability to conjure money at will. It doesn't even have to print paper dollars anymore. It can just mark up banks' electronic reserve accounts. But despite all the zeros' and ones' worth of cash it has coded into existence, it's by no means clear that the recession is over. Or even that it will be soon.

What Krugman's suggesting is one possible explanation for the extreme policy's failure to stimulate the economy quickly; the liquidity-trap argument implies that once banks have access to the money, they don't invest in activities that will spur the economy, such as business or consumer loans or securities. Instead, they can use it to shore up their balance sheets (against risky assets they're already holding), acquire other companies, or buy safer long-term instruments like government debt. All the new cash ends up trapped in the financial sector and doesn't reach the wider economy. In other words, they're hoarding our cookies.

Unfortunately, there's no easy way out of a liquidity trap. The Fed is in a classic Catch-22: Reducing the money supply by selling bonds and raising interest rates would worsen the willingness to lend and ability to spend across the economy, but the Fed also can't lower interest rates any further. So banks assume that what comes down must go up and are being frugal in anticipation of less-rainy days, when the government is no longer showering them with easy money. That leaves the fiscal policy—direct government spending in the economy—to do the heavy lifting. Financial firms won't lend freely until they are confident that their positions are sound in the long run. Until then, or until the stimulus package kicks in, the rest of us will have to try to keep clear of the quicksand.