05 May 2021

SUERF: How the Capital Markets Union can help Europe avoid a liquidity trap

Europe hasn’t yet fallen into a liquidity trap. Yet, the eurozone has only marginally spent or invested the massive amounts of liquidity injected into economies to combat COVID-19 shocks—indicating unproductive use of this money.

Key Takeaways

• We believe the EU’s Capital Markets Union can address this issue by encouraging savers to much more easily deploy cash in businesses or investments throughout Europe.
• In a post-pandemic world, the poor alternative to completing the CMU would be for EU states to raise taxes to fund small and midsize enterprises, which suffer from a large equity gap.

Is Europe caught in a liquidity trap? Or, is it close to being ensnared? A liquidity trap occurs when consumers and businesses prefer holding to investing cash because returns on other investments are too low. This frustrates a central bank’s ability to ease financing conditions enough when inflation is too low, because demand is depressed: Money may be created but is then simply held in cash balances rather than spent or invested. Europe has often been seen at risk of falling into the liquidity trap, particularly EU core countries, as economist Paul Krugman argued some years ago (see “Europe’s Trap,” The New York Times, Jan. 5, 2015). Such a risk might be even higher now. The yield curve in EU savings-rich core countries is currently flat at near zero, and bank deposits by households and corporates are at 126% of GDP, after governments extended financial support to workers and companies so they could withstand COVID-19 shocks.

The statistical evidence suggests that Europe has yet not fallen into a liquidity trap, but the use of savings remains unproductive

European households and corporates have hoarded a large share of the liquidity that governments and central banks have injected into the economy to combat the fallout from the COVID-19 pandemic. However, that does not mean Europe has fallen into a liquidity trap. After all, Europeans have had little opportunity to spend amid strict lockdowns. When restrictions to demand were lifted temporarily in summer 2020, households spent freely and scaled back their savings considerably. What’s more, productive investment—that is, in fixed capital or immaterial assets for enterprises, to be used for the production of goods and services--has been fairly resilient last year, even though many corporations reduced capital investments somewhat as a precaution. In fact, growth in productive investment has been increasing faster than value added since the European Central Bank introduced negative interest rates and quantitative easing in 2014. So, monetary policy does not seem to have lost all of its power...

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