What is liquidity trap, a term doing the rounds in the context of the crisis in the US and Euro zone?

Prabhat Khandelwal, Jodhpur

It is a situation where there is ample liquidity in the system but no investments in productive assets are forthcoming. This may be due to a variety of reasons. Investor confidence might have reached a plateau. Imports from abroad might stymie domestic investments. These precisely are in evidence in the US. The system is awash in dollars, yet domestic investments and employment are not improving. Liquidity trap is a caution to the pump-priming enthusiasts. There is a limit to which increasing the liquidity can tone up the moribund economy. The resultant improvement in purchasing power might actually be fuelling inflation, thus giving rise to economic bugbear — stagflation — inflation without increase in production capacities.

Currency union

What exactly is the root cause of the problem in the European region?

Santosh Rane, Pune

In my mind, the root cause is the incomplete nature of the union. You have the European Central Bank, whose writ runs all over the union. Thus its remit is to make the monetary policy for the entire European Union. But the fiscal policies are in the hands of the individual nations. This was a clear recipe for disaster. With nations pursuing their own economic agendas on the back of independent fiscal, manufacturing and labour policies, the power keg was waiting to explode. Laggards took it easy, counting on a bailout from better performers. Germany is actually ruing its decision to have spearheaded the union.

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