The danger in such a situation is that it can become unstable as weak demand and uncertainty cause companies to hold back investment and households to postpone spending. With the balance of savings and investment deteriorating, the equilibrium real interest rate falls even further. At the same time, wages and prices are forced down, pushing actual real interest rates higher. A deflationary spiral results. That is not the only danger. Attempts to reach a very low or negative equilibrium real interest rate – both through conventional reductions in short-term interest rates and through unconventional asset purchases – can risk generating unbalanced, unsustainable demand. In particular, as my predecessor Mervyn King has emphasised, by encouraging spending to be brought forward from the future and debt to be accumulated in the present, a greater shortage of demand tomorrow will develop unless the income of those who have taken on  2  BIS central bankers’ speeches  the debt picks up.2 If it does not, monetary policy will have to “double down” in order to sustain demand. Such compounding stimulus could promote financial vulnerabilities through an indiscriminate search for yield, a compression of risk premia to unsustainable levels or via extrapolative expectations of future asset prices. Perceptions of a “central bank put” – where the market interprets all bad news as good news because it will be met with more central bank stimulus – can reinforce these risks. When the inevitable correction finally occurs, the shortfall in demand and scale of the liquidity trap is insurmountable.

To the extent that this allows skills to be retained and reduces costs of replacing  3  In economists’ jargon, the extent to which potential supply is endogenous. This opens the possibility of there being “multiple equilibria”, something my colleague David Miles has reminded us was a central message of Keynes but that has been lost to much of the latest generation of New Keynesian modelling. See “Monetary Policy and Forward Guidance in the UK”, a speech by David Miles, available at: http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech681.pdf. 4  David Reifschneider, William L. Wascher, and David W. Wilcox (2013). “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy”, Finance and Economics Discussion Series 2013–77. Board of Governors of the Federal Reserve System (U.S.). http://www.federalreserve.gov/pubs/feds/2013/201377/201377abs.html. 5  See Alina Barnett, Maria Barriel, Adrian Chiu and Jeremy Franklin. “The Productivity Puzzle: Firm-Level Perspectives”, Bank of England Working Paper, forthcoming. 4  BIS central bankers’ speeches  particularly skilled employees as the recovery takes hold, the recovery could generate greater supply capacity and real wage growth as it proceeds. It would be unreasonable to expect these positive outcomes to materialise immediately. Weak growth may have meant that companies have missed out on productivity advances that would otherwise have been made through learning by doing. Skills have atrophied through underemployment rather than unemployment. The recovery will therefore need to be sustained for a period before productivity – and real wage – gains can resume in earnest.