Full Employment Liquidity Trap” may sound like an oxymoron, but this phenomenon does exist in Japan, Europe and in many other places.
For example, both Japan and Germany have been stuck in a liquidity trap, where interest rates have fallen to below zero for a long time. However, unemployment rates in both economies have been falling sharply this decade.
Japan’s unemployment rate stands at a 27-year low of 2.2% as of today, while it is 3.7% in Germany, the lowest since 1970, according to Bundesbank statistics.
Looking at the unemployment rate alone, one would conclude that both the German and Japanese economies have been in a prolonged economic boom.
In reality, however, both have suffered economic stagnation, low inflation or deflation for long, and are now teetering on the brink of “technical recession” – again.
The perverse combination of a “liquidity trap” and a very low unemployment rate forms a stark contrast to what John Maynard Keynes originally envisioned in 1936.
At the time, Keynes thought that the liquidity trap would be a rare occurrence where interest rates would fall to too low a level that monetary authorities would lose control over the economy.
He believed that only a financial crisis could push an economy into such a trap where aggregate demand is destroyed and “liquidity preference” becomes “absolute.”
As such, soaring unemployment and price deflation are the inherent characteristics of a classic “Keynesian liquidity trap”.
Japan was in a classic “Keynesian liquidity trap” for nearly 25 years, precisely, from 1995 to 2010. During this period, Japan suffered stagnating growth, price deflation, zero interest rates and a high and rising unemployment rate. Since the beginning of this decade, however, Japanese labor market conditions have begun to quickly change.
While interest rates have stayed at extraordinarily low levels and economic growth continues to stagnate, Japan’s job openings have been increasing, the number
A similar phenomenon has also become evident across Europe in general, and Germany in particular. Germany’s unemployment rate peaked out in 2005 and has fallen precipitously since, with the 2008 Global Financial Crisis only briefly interrupting the broad downtrend.
Such a large and uninterrupted fall in unemployment has occurred against the backdrop of Germany’s stagnating economic growth, zero to negative interest rates and very low inflation, especially since 2010.
The primary suspect that has caused this “full employment liquidity trap” is an aging population. If an economy experiences a stagnating or even shrinking labor force, its natural unemployment rate must fall precipitously.
To think about this issue more clearly, assume an extreme hypothetical case where only 10% of the population is in the prime-age labor force, with the rest either too young or too old to work. In this case, the “natural unemployment” rate should be zero, but the size of the economy must also shrink.
Although Japan’s unemployment rate is approaching