This explains it rather well...
The badly damaged process of wealth generation has severely impaired true economic growth, and obviously this has severely reduced good quality borrowers and subsequently has reduced banks willingness to lend. Remember that in essence banks actually lend real wealth by means of money. They are just intermediaries. Obviously then, if wealth formation is being impaired, less lending can be done. We suggest that it is this fact alone that explains why all the pumping by the Fed has ended up stacked in the banking system. So far in early May banks have been sitting on over $1.7 trillion in surplus cash. In January 2008 surplus cash stood at $2.4 billion.
Given the high likelihood that the process of real wealth generation has been severely damaged, this means that the pace of wealth generation must follow suit. Now, contrary to popular thinking an increase in government spending cannot revive the process of wealth generation, but on the contrary it can only make things much worse.
Remember government is not a wealth-generating entity, so in this sense increases in government spending generate the same damaging effect as monetary printing does; it leads to the diversion of wealth from wealth generators to wealth consumers. Observe that in 2012, US government outlays stood at $3.538 trillion, an increase of 98 percent from 2000.
As long as the rate of growth of the pool of real wealth stays positive, this can continue to sustain productive and nonproductive activities.
Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more wealth than the amount it releases.
This excessive consumption relative to the production of wealth leads to a decline in the pool of wealth.
This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. The shrinking pool of real wealth exposes the commonly accepted fallacy that loose monetary and fiscal policies can grow the economy.
Needless to say, once the economy falls into a recession because of a shrinking pool of real wealth, any government or central-bank attempts to revive the economy must fail.
This means that a policy such as lifting government outlays to counter the liquidity trap will make things much worse.
Not only will these attempts not revive the economy; they will deplete the pool of real wealth further, thereby prolonging the economic slump.
Likewise any policy that forces banks to expand lending “out of thin air” will further damage the pool and will further reduce banks’ ability to lend.
Again the foundation of lending is real wealth and not money as such. It is real wealth that imposes restrictions on banks’ ability to lend. (Money is just the medium of exchange, which facilitates the flow of real wealth.)
Note that without an expanding pool of real wealth, any expansion of bank lending is going to lift banks’ nonperforming assets.
Summary and conclusion
Contrary to various experts, we suggest that in the current economic climate an increase in government outlays is not going to make Fed’s loose monetary policies more effective as far as boosting economic activity is concerned.
On the contrary, it will weaken the process of wealth generation and will retard economic growth.
What is needed to get the economy going is to close all loopholes for money creation and drastically curtail government outlays.
This will leave a greater amount of wealth in the hands of wealth generators and will boost their ability to grow the economy.
http://mises.org/daily/6436/Drowning-in-a-Liquidity-Trap
