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What happens when interest rates hit zero, and people still don’t want to borrow? That’s the story that unfolded in Japan twenty years ago, but, as far as the West is concerned, a liquidity trap is academically interesting, practically irrelevant – at least that is what we were being told until quite recently. It’s different now, and it does rather seem as if the West may be experiencing liquidity trap type conditions.  In Japan such a scenario spelt disaster for equities. But what about equities in the UK, Europe, and the US? Will they follow the Japanese trajectory and fall faster than a snowboarding delegate at Davos?
Exactly what we mean by a liquidity trap does seem to depend on who you want to listen to. Keynes saw it terms of yield on bonds, and described a liquidity trap as occurring when the yield on bonds had fallen so low that the yield was not sufficient to compensate for the risk of capital loss. In such a scenario, bond yields could not fall lower.

Paul Krugman revisited the idea in the 1990s and in his model interest rates fall to zero, but inflation expectations are so low that not even a zero interest rates can encourage borrowing, or persuade people to hoard less cash. In other words, in the Krugman model, deflation could mean that even when rates are zero, real rates – that’s allowing for inflation – could be too high.

And since this is pretty much what happened in Japan, the idea of a liquidity trap started to worry economists.  It is the kind of thing that keeps central bankers awake at night.

The evidence to suggest we are currently in a liquidity trap scenario seems pretty clear. Now the Fed is indicating that rates will stay at near zero until at least 2014, it seems to not matter how much money it prints, (or to put it in economic terms, the level of the monetary base), neither people nor companies are spending enough.

So what does that mean for equities?

The fairly obvious fear is that when this happened in Japan, equities just kept falling.

Writing in the ‘FT’, Gavyn Davies argued that it is different this time. His core argument boils down to earnings yields. In Japan, in 1997, which was a kind of worst point, the earnings yield on equities was around 2 to 2.5 per cent, much the same as the yield on bonds. As Mr Davies put it: “The nominal risk premium on equities relative to bonds was therefore zero.”

In contrast, the earnings yield on the S&P 500, or so says Mr Davies, is currently 4.6 to 4.7 per cent, which equates to an equity risk premium of around 3 per cent. For the UK and Germany, he says the risk premium is higher still and higher again for the Eurozone.

As for bonds, he argues that actually this is quite a risky investment at the moment. Let’s face it, their yield is not going to fall much further, therefore any capital gain from holding bonds can only be quite modest. But, on the other hand, the potential for yields to rise is enormous, meaning bond investors risk quite substantial capital losses.

So what’s the conclusion? Well, Mr Davies is saying that equities are looking good.

But not so fast. Capital Economics has taken look at the Davies argument, and disagrees.

“If the liquidity trap became much deeper,” says John Higgins at the consultancy, “the economy would likely slide into deflation. Owing to the zero bound on nominal yields, the realised real return on conventional Treasuries would thus become increasingly positive as the rate of deflation increased.”

And his conclusion: “Although today’s earnings yield in the US, at around 4.6 per cent on an inflation and cyclically-adjusted basis, is higher than it was in Japan in the years after the latter’s bubble burst, it is much lower than in the deflationary years of the Great Depression, when it peaked in the US at around 18 per cent in 1932.”

But drill though it all and what are we left with?

Well, when rates are near or at zero, we may well suffer liquidity trap conditions. But Japan also suffered from deflation. Its equities relative to bonds were at similar price levels, and, in times of deflation, fixed income wins. Today, equities are cheaper relative to bonds, suggesting they are a good buy – unless that is you believe some form of deflation is around the corner, in which case corporate earnings may fall, suggesting they are currently too expensive.

Or to put it more simply still, equities are cheap unless you think real profits are going to fall.

These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees