COVID-19 fear & liquidity trap: Why mass fear needs to be tackled

Extraordinary times call for extraordinary measures, and this is probably the textbook definition of the phrase “extraordinary times”. The pandemic, the unexpected and unprecedented global lock-down and the coordinated policy actions by governments across the world, was not something that had been built in by professional forecasters for 2020. Sanitization of public places and homes is essential but equally important is to address fears to contain economic contagion that may be already showing up as what we economists call a liquidity trap.



We are in uncharted territory where herd mentality overpowers logic and deliberation. Liquidity trap is one outcome where masses anticipate and prepare for adverse economic or geopolitical situations by hoarding cash. Monetary policy becomes ineffective as demand for money does not increase even when the interest rates are near zero (free money). Very simply put, demand does not pick up even on free money due to fear around uncertainties. Liquidity trapped is marred with deflation and deflationary expectations that become self-fulfilling.

As discussed in my last post, policy will play an important role in ensuring that we avoid the liquidity trap. Not only in terms of the traditional monetary and fiscal policies but also in terms of communicating to reassure the masses that this setback is being tackled on all fronts. Solid communication strategy that includes social media channels for mass coverage will go a long way in instilling confidence in public. On the individual level, the way forward is to realize that a crisis is an opportunity. This may be perhaps the best time for opportunistic investments - irrespective of asset class. We need to keep sight of the fact that this is not the first negative shock to global economy and that the economy will rebound. This too shall pass though it may seem like the end of the world right now.

A rather morbid statement to make given the situation, “what does not kill you, only makes you stronger” could not have been more true.

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