Several commenters asked me why the liquidity trap hypothesis implies that countries are unable to devalue their currencies in the forex markets. There are several ways of answering this. A liquidity trap implies the central bank cannot inflate, but currency devaluation tends to raise the price level.
But that doesn’t really answer the question. It seems obvious that countries can devalue, why do the Keynesians think this becomes impossible at the zero bound?
Here’s why people are confused. We’ve been taught that “liquidity traps” are all about the zero lower bound on nominal interest rates. That does play a role in the hypothesis, but on closer inspection it’s actually another zero bound that is crucial, the zero lower bound on eligible assets not purchased by the central bank.
Think about the common reply to liquidity trap worries; “The central bank could buy all the assets on planet Earth–surely that would depreciate the currency!” Yes, but then Keynesians raise practical objections:
1. The central bank can only legally buy certain assets.
2. The central bank may be fearful of having a large balance sheet.
Those objections then become the real reason for monetary policy ineffectiveness, not the zero bound. Some argue that monetary policy crosses over into being fiscal policy in this area. I disagree; the EMH implies the expected gains and losses on purchase of foreign government bonds is roughly zero. Even unconventional OMOs simply do not have the fiscal implications (futures tax liabilities) of government spending.
Now that we understand that the real problem is not enough eligible assets, or unwillingness to expand the balance sheet, it becomes clear why some countries (in their view) cannot devalue. In order to peg the exchange rate at a lower level they’d have to sell so much domestic currency that their balance sheet would swell to unacceptable levels. So there is a theory there.
Evan Soltas once showed that as soon as the Swiss National Bank finally bit the bullet, devalued, and then set a firm peg of 1.2/euro, they actually needed to buy fewer assets than before. So although the worry about balance sheets might provide some sort of theoretical justification for liquidity traps, as a practical matter it’s simply not an issue. The real problems lie elsewhere–refusal to set a robust enough NGDP target, and do level targeting.
PS. The exchange rate does help in one respect. It forces people out of the horrible Keynesian/Woodfordian “rental cost of money” approach to monetary policy, and into a much more enlightening Fisher/Warren “price of money” approach. By doing so it allows us to think about the problems much more clearly, and suddenly some of those Keynesian interest rate-oriented concerns seem to fade away.