Philip Pilkington — What is a Liquidity Trap?

Perhaps the worst thing that can happen to a term in any language is that it loses completely its meaning and becomes a sort of floating signifier that can attach itself to any old nonsense. Such is the case today with the term “liquidity trap”.

Fixing the Economists
What is a Liquidity Trap?
Philip Pilkington

JW Mason comments at FB

I don't care for Krugman's use of the term either, but he is closer to Keynes than this rather confused post.

Keynes gives a precise meaning for "liquidity trap": A situation in which changes in the relative quantities of more and less liquid assets do not change their relative price. This occurs when interest rates have fallen sufficiently that the pool of "bull speculators" is exhausted -- i.e., there are no longer market participants who believe that interest rates will be lower in the future. If all market participants expect a future rise in interest rates, and hence a capital loss on bond holdings, the premium required to hold bonds will prevent any further fall in rates. Thus, the essence of the Keynesian liquidity trap is a consensus among participants that future interest rates will not be lower than current rates.

(This argument cannot even be stated in the language of contemporary economic models, based on uniform "rational" expectations.)

Keynes' liquidity trap has nothing to do with the premium on safe assets, as captured by measures like the TED spread. It is a story about the importance of expectations, and specifically the importance of a *diversity* of expectations about future interest rates.