Back when I studied economics in college, a liquidity trap was something that happened (1) before the New Deal and/or (2) to small economies run by dorks. Of course, that was before the Japanese crisis.
And, almost, it's our turn. No wonder the Fed is freaking out.
Paul Krugman's Blog, How close are we to a liquidity trap?:
Here's one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don't do anything, because you're just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there's no incentive to lend out any increase in the monetary base, because the interest rate you get isn't enough to make it worth bothering.
As of 10:38 this morning, the one-month Treasury rate was 0.57; the three-month rate was 0.825.
Are we there yet? Pretty close.
Cf. Krugman, Thinking About the Liquidity Trap (1999).
Although my macro is very rusty — I always liked micro better — it seems to me that the large pre-existing deficit overhang puts some nasty limits on the government's ability to do stimulative fiscal policy: the expectation that paying it all back will be brutal acts as a nasty brake on the stimulative effects.
The sinking dollar, on the other hand, seems more of the mixed blessing. Foreign investment, good in the short run, not so good in the long run (as they lead to more fiscal outflows). Better would be increases in foreign demand. And how's that big mac index looking today?