The Paradox of Inflexibility

In my previous blog post, I mentioned a forthcoming paper by a co-author and I. It is a simple paper that shows how one can explain to undergraduates the macroeconomic behavior of an economy that is stuck in a so-called 'liquidity trap.' At the liquidity trap, interest rates are at the 'zero lower bound;' interest rates have been reduced as far as they can be reduced and cannot be reduced any further.

At the zero lower bound, a whole raft of paradoxical results -- with names like "paradox of thrift," "paradox of flexibility," and "paradox of toil" -- appear. A new NBER working paper by David Cook and Michael B. Devereux ("The Optimal Currency Area in a Liquidity Trap," NBER Working Paper No. 19588, http://www.nber.org/papers/w19588) derives yet another paradoxical result.

Cook and Devereux argue that -- contrary to the received wisdom that a monetary union (such as the European Monetary Union) makes its member economies more vulnerable to economic shocks -- in a liquidity trap a monetary union may makes its member economies less vulnerable!

Countries that form a monetary union agree to give up their national currencies and adopt a common currency. And, as Greece, Portugal, and Ireland have discovered the hard way, not having a national currency can drastically reduce a country's ability to fight its way out of a recession.

Normally, when a country finds itself in a recession, its central bank prints a lot of money and spends it on financial assets (bonds, typically). Buying a bond from somebody and paying him cash for it is really just the same as lending him money: you pay him money now and he promises to pay you money later. Consequently, the new money printed (and spent) by the central bank essentially turns into a gusher of loans. Borrowing becomes cheap and interest rates fall. Lower interest rates lead to increased spending by households and businesses. The rise in spending leads to an economic recovery. Everybody breathes a sigh of relief.

Unfortunately, a country without its own currency would not be able to take any of the recession-fighting measures just mentioned. If the members of a monetary union are similar enough that their business cycles are perfectly aligned, then when one member is in a recession all other members would also be in a recession. In such a case, tons and tons of the common currency could be printed and used in the usual way to pull all member economies out of the recession. But when the member economies of a monetary union are vulnerable to "asymmetric shocks," a member economy that falls into a recession does so alone. And it would have no independent monetary policy to help it escape the recession. This is why, monetary unions have been frowned upon by economists, except for countries that belong to an "optimal currency area" where their economies are always in sync and economic shocks are symmetric.

Cook and Devereux argue that the above argument against monetary unions is turned upside down when interest rates reach zero and, therefore, cannot be reduced any further.

First, when interest rates reach zero and cannot be reduced any further, the lack of a national currency is no handicap; after all, monetary policy would be ineffective even in a country that does have its own currency.

Second, a country with its own currency might see the exchange value of its currency rise and thereby cripple its economy by reducing its exports and raising its imports. A country that is in a monetary union and, therefore, has no currency of its would not face such a danger.

Consider a country that has its own currency, and happens to be at the zero lower bound. Now, suppose there is a fall in demand that brings about a deeper recession. Falling demand would lead to falling inflation. With the nominal interest rate stuck at zero, falling inflation would cause the real (or, inflation-adjusted) interest rates to rise. The rising real interest rates would attract foreign lenders. All this borrowing from foreigners would -- by the balance of payments identity -- lead to a yawning trade deficit. To see this in another way, note that when foreigners, eager to earn the rising real interest rate in a country, buy the local currency in order to lend to the local residents, the country's currency would rise in value. A more expensive currency would reduce exports and increase imports.

Obviously, if a country that is already in trouble from falling demand now faces falling exports and rising imports, it would only be digging a deeper grave for itself.

Cook and Devereux explain that a country that is a member of a monetary union would not have to face the above predicament. Not having a currency of its own, it runs no danger of its currency appreciating in value and thereby crippling foreigners' demand for its products.

Cook and Devereux make an argument that is persuasive, surprising, and simple.