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The Liquidity Trap Isn't Likely To Be Sprung

Economic Trends


Despite the Federal Reserve Board's recent easing, many observers fear that the economy is caught in what John Maynard Keynes termed "a liquidity trap," in which falling interest rates fail to revive flagging business activity. They note that debt-burdened households and businesses are reluctant to borrow more, and banks are clearly skittish about making new loans.

Economist Mark M. Zandi of Regional Financial Associates thinks the liquidity-trap argument is overdone, however. For one thing, he notes that falling interest rates will cushion the burden of debt for both individuals and companies.

Zandi estimates that nearly a third of all residential-mortgage debt, including home-equity loans, adjusts to market rates. Thus, the roughly 125 basis-point decline in short-term rates since August will save homeowners some $9.35 billion in 1991--about a quarter of last year's rise in consumer spending. And 44% of nonfinancial corporate debt adjusts within a year, so the decline in short rates should shave more than $10 billion off corporate interest costs this year.

Finally, Zandi points out that the current bank credit crunch "is less onerous than declines in bank lending in past recessions." In earlier slowdowns, limits on deposit rates led consumers to withdraw their savings from banks and thrifts, forcing banks to curtail lending. In the 1974-75 recession, for example, commercial banks' total loans, adjusted for inflation, fell 8%. In 1980, they fell 7.2%, and in 1982 (when limits on deposit interest rates were partly phased out), they declined by 3%. In contrast, today's total loans outstanding at commercial banks, adjusted for inflation, are off by only 0.7% from their year-earlier level.

In short, says Zandi, "the economy is unlikely to be mired in a liquidity trap as long as the Fed continues to ease."GENE KORETZ

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