Saturday, March 23, 2013

Maybe it is time to talk devaluation

Here's my most radical thought yet about what the United States could do to bring about a recovery: currency devaluation.

The way I'm looking at it, this would bring on a few somewhat related effects that would be beneficial in the current liquidity-trap environment:

(1) boost exports/decrease imports. As common sense tells us, if the cost of buying things from a country goes up, it becomes more attractive for foreigners to buy that stuff, which would increase exports. Devaluation also means that foreign goods would seem more expensive, so imports would decline.

(2) raise inflation expectations. As stated in (1), the prices of foreign goods in terms of domestic currency would rise, so the price level for domestic goods would be expected to rise so that a new equilibrium domestic price level would develop. It might not work as well as one would hope, however, because of the share of global trade that the U.S. has. If exports from the US go up and imports go down, the global price level could decline somewhat. The result should still be positive, just not as effective as a similar policy for a small economy.

(3) end of the liquidity trap. If a devaluation occurs, the liquidity trap which the U.S. economy faces could end . When inflation expectations pick up, the real interest rate will decline, potentially enough that the nominal interest rate targeted by the Fed could rise above the current rate, which is against the zero lower bound (ZLB) without raising the real interest rate.

I can think of reasons this would not be such a good policy. Among others, it would immediately give everyone with US dollar-denominated assets a "haircut", but I am also cognizant of the constraints which may make a first-best policy impractical. The Federal Reserve Board seems unwilling or unable to bring about a quick recovery from this depression. The state and local governments are unwilling or unable to spend enough to bring about recovery within their jurisdictions. The Federal Government is unwilling to undertake any policy other than a premature austerity. Maybe a devaluation is the fourth-best policy (laughs sardonically).

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