Almost everyone I talk to loves working from home. What’s not to love? No commute, no dry cleaning bills, rescheduling meetings is way easier, and there’s no need to pretend to be busy when your boss is around. No doubt, personal productivity, and convenience have increased.
The problem is, working from home is causing us to spend less money. When you combine a high savings rate with extremely low-interest rates and an economic recession, a liquidity trap can form. Compounding the problem, many companies are thinking of continuing the work-from-home trend. There’s talk of a four-day workweek. Facebook looks serious about expanding remote work. Twitter announced nearly a year ago employees can work from home, indefinitely.
Unfortunately, a strengthening liquidity trap creates a real dilemma for central banks and is a serious risk for an already fragile economy. Could a post-pandemic continuation of the work-from-home trend make the liquidity trap worse? The short answer is yeah, it definitely could.
In this article;
- What is a liquidity trap?
- Why continuing remote work could strengthen the liquidity trap
- Why getting out of a liquidity trap creates economic risks
- Final thoughts
What is a liquidity trap?
A good old-fashioned liquidity trap is when interest rates are already extremely low and at the same time, investors start hoarding cash rather than investing it because they’ve lost confidence in the economy.
A liquidity trap is a real problem for central banks because it takes away the power to stimulate the economy the more conventional way — by lowering interest rates. With interest rates already near zero, central banks need to use more unconventional means like the junk bond backstopping we saw in 2020 to re-establish economic confidence. Unfortunately, unconventional stimulus has consequences. For example, the Federal Reserve's decision to back junk bonds has seriously distorted price discovery, which has at least partially led to the froth we are currently experiencing in some stocks, bonds, and real estate.
When confidence is lost in the economy, investors may move to cash in anticipation of a sudden drop in real estate prices or the stock market. When caught in a liquidity trap, central banks try to rebuild confidence by adding unconventional stimulus — but if central banks don’t get the balance just right, a few bad outcomes can happen;
- Inflation can rise above targets. In this case, interest rates would need to rise to slow inflation. Rising interest rates are bad for bonds and they aren’t great for stock prices either.
- On the other hand, if central banks fail to achieve low inflation targets the recession may continue. If the recession continues long enough, company profits will be hurt and elevated stock prices will have to re-set lower.
- Interest rates may have to be raised quickly. If in an attempt to escape recession central banks allow inflation to get too far ahead of targets, interest rates may need to be adjusted higher to cool the economy. This risks triggering a Japanese-style deflation. Obviously, if deflation starts a negative wage-price spiral, it’s bad for stocks, real estate prices, and the health of the economy.
The 2021 liquidity trap comes with an unusual twist
The newly formed 2021 liquidity trap is special because it comes with an interesting twist – people are saving unusually large amounts of cash but not necessarily because they have lost confidence in the economy. Of course, some people fear their unemployment benefits will run out and they won’t be able to find a job with unemployment still stubbornly high. However, many people are doing just fine but are also saving unusually high amounts of money simply because they are working from home.
According to Statista there is over $2 trillion currently sitting in personal savings. In good economic times, people tend to spend more and save less. When the economy slows, we tend to save more in anticipation of tougher times ahead. Although it’s come down a lot, the US still has a savings rate nearly double the normal long-term savings rate.
Why continuing remote work could strengthen the liquidity trap
When central banks lower interest rates they’re not trying to increase the prices of stocks or real estate. Central banks lower interest rates when they are trying to decrease the unemployment rate. Getting people back to work and spending money ends recessions. The liquidity trap could continue to strengthen if people anticipate more bankruptcy and high unemployment due to weaker than normal consumer spending.
With businesses working from home or forced to close, brick-and-mortar businesses and the employees who work for them have faced the economic brunt of the pandemic. Even with access to loans and grant money, a tremendous number of businesses had to close their doors in 2020 due to decreased customer spending.
Without a full return of remote worker spending, it seems that at least to some degree the bankruptcy trend in the face-to-face service industry is going to continue. If so, the liquidity trap is likely to only strengthen, making escaping recession that much harder.
The Café and Aurora Sports bar – Fairview, Canada
Fairview is far from any big city but that has not saved local businesses from the devastating effects of the pandemic. Even though Fairview is mainly a farming community, the work-from-home trend still has had a significant impact on local businesses.
“The fact is that with people working from their homes they don’t go out for lunch. They used to when they’re working in an office, they might go grab a sandwich somewhere and a bowl of soup. When you’re at home you are going to probably make something at home. That makes a big difference.” — Betty James, February 23, 2021 — The Fairview Post Online
In an all-too-common example, staff has been cut in response to shutdowns and lower spending and hours for remaining staff have been cut due to shorter hours of operation.
“We’ve still got a long way to go to even a comfortable zone. I don’t think we’ll ever get back to the normal as we know it. But if we could get back to a comfortable zone sort of speaking. That would be nice,”
Service industry business owners are starting to realize business may never be the same as it was pre-pandemic because every time an employee works from home another potential sale is lost.
Why getting out of a liquidity trap creates economic risks
Traditional ways to get out of a liquidity trap include;
- hoping the situation will regulate itself as prices fall to attractive levels (stocks and real estate remain historically well ahead of the underlying economy, so either stock valuations must fall or economic output must explode),
- raising interest rates (bad for stocks and bonds, particularly if they rise too much or too quickly),
- or increased government spending to create jobs and get more money into the hands of everyday people (what the Democrats are trying to do with their $1.9 trillion COVID bill and $15 minimum wage).
Remember, this is a liquidity trap with a twist. Just like no one will buy anything from brick-and-mortar before at least quickly checking prices on Amazon, there is a real possibility a significant portion of working hours will shift permanently from office to remote work.
Bubbles end when investors lose confidence. If a large percentage of us continue working from home and the services industry struggles to recover, then a significant correction in both real estate and stocks could be in the works.
All Stock Market Bubbles End
3 events that have preceded the end of every stock market bubble
If the Federal Reserve over-stimulates and the economy responds strongly, we could easily experience that high inflation mentioned above. On the other hand, if there isn’t enough stimulation, we know a liquidity trap can drag an economy back into recession. This means option 2 is also a significant threat both to the stock market and the economic recovery because getting the balance just right is no easy task for the Federal Reserve.
Will the Federal Reserve Save the Economy?
2 times central banks got interest rate hike timing wrong
Finally, we have the government spending option. If Democrats pass legislation to cause their election promises to be fulfilled, it should (at least in theory) bring confidence to the economy. However, critics warn a massive government spending plan could overheat the economy and a $15 minimum wage could hurt business and cause further job losses.
Unfortunately, it seems there are no easy answers for getting out of a liquidity trap.
This liquidity trap will eventually end one way or another. How this liquidity trap ends is likely to have significant consequences for investors. Of course, diligence, research on stocks investors own, and an investment strategy are all needed. However, ultimately how the liquidity trap ends might not be the biggest problem over the longer term.
With remote work continuing, it seems likely many service industry companies will not fully recover, possibly for years. This in turn will result in more job losses and downward pressure on salaries.
We also know many remote-work-friendly companies like Facebook intend to keep most of their employees' savings by scaling pay depending on where the remote worker lives. Although this may not reduce the spending power of Facebook employees, it certainly won’t enhance it.
We’ve known for years that wages haven’t kept up with inflation and therefore the wealth gap between business owners and the workers who work for those businesses has grown steadily. What I fear the most about a significant continuation of remote work is that it will only cause the financial gap to widen even further.