First of all lets make something clear about zero lower bounds and costs of holding liquidity, and money in general. Money, whatever form it might take, is a nominal financial asset, just as a bond, perpetuity, or T-bill. It just happens to be a zero coupon consol.
Hence, the zero-lower-bound allpies for nominal interest rates, where at negative rates the non-financial sector can still choose the instrument with zero coupon. Actually in today’s financial world it’s not true either, since you can not use cash for all your transactions. Also there is a risk of losing the money, or the cost of keeping it safe, the “zero-lower-bound” is rather somewhere in the negative territory, I have seen various estimates, going from -2 to -6 percent.
According to classical economic theory, as real interests rates drop you hold more liquid money, as the opportunity cost is lower. Case closed.
I would disagree. The real cost of holding liquidity also depends on its return compared to alternative investments, nominal or real, inflation affects both in the same way. Liquidity traps doesn’t occur, cause real returns are near zero. They occur, cause the real return of holding money is a.) close to its alternatives b.) relatively high. By the latter I mean, that during normal times when inflation is positive you have a negative real return with this zero coupon, while at zero inflation holding money has no cost in real terms. That said lets consider the ways we can get out of such economic malaise.
Why can it be a quicksand?
In my view the best proxies as alternatives to holding cash (considering liquidity, affordability, and default risk) are safe bonds/consols. Theoretically one could consider any type of asset, but that would rule out a possibilty of negative real rates, since something (by definition) has to appreciate against everything else. It would be like saying, that you can earn double your money each year, you just have to be always at the right time and place. That would be just nonsensicle and extremly naive.
So realistically speaking safe bonds are good proxies, and even though they do not default you can earn a nice negative real return on it. That happened quite often during the last bear markets. The problem is that you have no haven option. You can stockpile into real assets (gold, REITs, stock ETFs), but that requires higher risk tolarence, and on a macro level also risks bubbles.
The problem with our current situation that IF inlfation picks up on the longer horizon, and IF central banks raise too soon they risk the offsetting of the recovery. If they are too slow noone would hold money/bonds, and an excessive amount of money would flow into commodities, raising inflation even higher. Precision will be required… for me it looks that we are in an eternal trap, where normalization is not viable in the short run.