tl;dr By taxing a nation's capital stock, governments can induce consumption and deter hoarding, resolving the liquidity trap.
A liquidity trap is a situation decribed in Keynesian economics in which the injection of cash into the private banking system by a central bank fails to lower interest rates and hence fails to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.
Deflation is a problem on its own, because it comes with a nonnegligible probability that the economy enters a deflationary spiral, which is a situation where a decrease in prices leads to lower production, which in turn leads to lower wages and lower demand, which further decrease prices, and so on. Thus, reductions in prices may lead to a vicious circle - one that is hard to break.
During Japan's lost decade, the Bank of Japan unsuccessfully tried to stimulate the economy through quantitative easing. In the process of attempting to stimulate the economy, the Japanese central bank decreased interest rates to levels as low as zero percent. Given that nominal interest rates have a virtual lower bound of zero percent, a central bank loses its primary means to stimulate the economy through monetary expansion the moment interest rates reach this level. As a consequence, the liquity trap often is also referred to as the Zero Lower Bound Problem.
Liquidity traps remain a rather vague concept; overall there is little concensus on the causes or remedies, and as such it remains problem mostly unsolved. Nevertheless liquidity traps also remain a very relevant topic. Paul Krugman had fears that many countries in the developed world would enter a liquidity trap after the 2008 crisis, as the U.S. monetary base tripled between 2008 and 2011, but failed to produce any significant effect on U.S. domestic price indices, evidenced by inflation rates that have remained between -2% and 4% since the the crisis.
Krugman asserts that the described issue of monetary policy impotency is the direct result of a credibility problem; that central banks can always engineer inflation by convincingly committing to pursue inflation, and by ratifying inflation once it comes. Ben Bernanke essentially supports this vision, as he states that sufficient injections of money will ultimately always reverse a deflation. Krugman thus suggests the adoption of a managed inflation policy at a sufficiently high rate (4% for the given situation), which conforms to the views of Laurence Ball and Olivier Blanchard
I am not entirely convinced by the claimed effectiveness of managed inflation. Convincing markets that a central bank has the intention to target higher levels of inflation for sustained periods of time is the easy part. The hard part is to convince the market that a central bank actually has the means to do so. Central banks can only control inflation indirectly through a number of means, including short term interest rates; reserve requirements and open market operations. The problem is that the effectiveness of these methods is not guaranteed. One can easily think of situations under which pumping money into an economy does not affect price levels altogether. Imagine an economy saturated with debt: regardless of how cheap borrowing becomes, the saturated economy is not able to absorb more debt, because all economic agents have one thing on their minds, which is to reduce their debt. This is also a position that Richard Koo defends in his fascinating book. What this leaves us with is a sort of chicken-and-egg situation. In a sense, managed inflation is required to convince markets that a central bank is able to manage inflation; in a deflationary economy, markets can not be convinced by the prospects of inflation even if it believes the central bank's intent to target inflation.
In defense of the central banks, there are a number of more exotic means, such as debt relief, that become increasingly viable ways of inducing inflation when interest rates drop to zero percent, though the political consequences of such measures reach so far that one can argue that a central bank should stay away from these measures.
Not entirely convinced that a managed inflation policy is all it takes to break liquidity crises, I started exploring alternative mechanisms. It is known that there is a role for fiscal policies when it comes to combating liquidity traps. In order to stimulate consumption, central banks and governments can work together and initiate a money-financed tax cut. Such a tax cut increases spendable income, and should theoretically stimulate spending. However, as witnessed in Japan, increases any increase in spendable income would directly go to paying off debt or would be deposited in a savings account. Who can blame them? They just experienced the carrying of debt as a traumatizing event. Furthermore, as the consequence of deflation, saving a cash is utterly attractive because it buys you more products tomorrow than it does today.
Alternatively, expanding fiscal consumption could partially make up for the declining personal consumption during deflationary cycles. The downside is that if government consumption would substitute personal consumption, public debts would rapidly increase. Japan now has a public debt over twice the size of its GDP.
Keeping in mind the potential ineffectiveness of monetary policies, and the reasonable bounds of fiscal policies, I propose a different fiscal/political solution. When facing a liquidity trap, governments ought to restructure their tax income. To prevent people from hoarding savings - like the citizens of Japan did - governments can stimulate the economy by shifting the weight of tax income from Income Tax and Value Added Tax more towards Capital Tax. Capital tax comes in a variety of forms across the globe. For example, in the United States, there is a Capital Gains Tax, whereas in the Netherlands the tax authorities assume a theoretical capital yield of 4%, which is taxed at 30%, leaving us paying 1.2% on our average capital stock. Although I have many objections to the "Dutch" capital tax scheme (e.g. because it has counter-cyclical tendencies), it is the type of capital tax I recommend governments to adopt when the economy is stuck in a liquidity trap: tax the capital stock, rather than capital gains, and make ownership of capital expensive!
"It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable."
My proposal relies on the relation described in the quote above - a quote of Friedrich Hayek. When working and consuming become cheap, and the ownership of capital becomes expensive, excessive hoarding is fundamentally discouraged. Likewise, it becomes attractive to carry debt - even more so when the method is effectively raising expected inflation. An additional advantage of this kind of capital taxation is that there virtually is no bound to the extent that the measure can stretch. Though probably politically unviable, governments could go as far as to confiscate all non-spent income.
While writing this article, I came across an article by Marvin Goodfried, who proposes a carry tax on money to overcome the Zero Lower Bound Problem. Though the proposals are quite similar, the main difference between the two is that Goodfried suggests that central banks should levy a tax on bank reserves, whereas I suggest that governments should levy a tax on capital posessions of companies and households.
To conclude, I do believe that fiscal policies should play an important part in resolving a liquidity trap. This is because conventional monetary policies become virtually ineffective, even if central banks can convince markets that they intend to target a high level of inflation. More exotic monetary policies, such as debt relief and subsidized lending, could remain effective measures when interest rates are zero, but come each come with a set of problems and far reaching political implications. I am convinced that the restructuring of tax income by reducing Value Added Tax and Income Tax, and raising Capital Tax, can stimulate consumption and deter hoarding, which is exactly what the economy needs to break a deflationary spiral.