It depends on how necessary it is for those countries to have as
favourable “initial conditions” as Estonia. Whatever my
differences with Mr Krugman over Estonia’s policies, he has been right about
the general dangers of “debt overhang”, or the “debt trap”, for internal
devaluers.
Described by Irving Fisher in 1933, these overhangs and traps are
created as government and private austerity cut household and corporate cash
flows, so those borrowers are less able to service their debts. As more of them
default or fail, and as wages fall and unemployment rises, the government, in
turn, gets less tax revenue to service its debts.
Baltics’ debt problems were on different scale
14-Jul-2011 Estonian exceptionalism – The Economist
A rare bit of good news from a euro-zone economy
European crisis resolution seems to rest on one hope: austerity can
bring growth. History and most of economic theory seems to suggest that this is
not possible. The Baltics peg to differ. Or so it seems…A closer look shows
that the current Baltic recovery has not resulted from the internal devaluation
but rather from other factors not under the control of the Baltic governments…If
not internal devaluations, then what is behind the Baltic recovery in 2011?
There are two key factors: flexible labor markets and integration of export
sectors into key European production networks.
The Baltics ‘outsourced’ their recovery, and they did it very well…the
massive use of EU fiscal funds (20 percent of Estonia’s 2012 budget is EU
transfers) and extreme integration of the export sector with Scandinavian
producers…even if the EU periphery could somehow manage to replicate the
political conditions, they still would not have similar economic factors.
The strategy of internal devaluation succeeded in shrinking the real
(hourly) unit labour costs by 25 % per year in 2010 and 2011.
6-Jun-2012 Why Internal Devaluation Is Advantageous
– PIIE
Nominal devaluation has neither been necessary nor beneficial for the
regaining of competitiveness. On the contrary, if a country maintains a fixed
exchange rate, it is forced to undertake more structural reform, and is more
likely to do so.
6-Jul-2012 Internal adjustment of the real exchange rate: Does it work? – voxeu.org
Our findings suggest that internal adjustment can work, but is a very
painful process. In the Eurozone, these findings call for unit labour cost
increases and a slower pace of fiscal consolidation in the ‘core’ countries and
a weaker exchange rate of the euro.
6-Jun-2012 Estonian Rhapsody – Krugman /
NYT
20-Jul-2012 Krugmenistan vs. Estonia – BusinessWeek
Sep-2012 Can struggling eurozone
countries achieve necessary ’internal devaluation’ – and at what political
cost? – Open
Europe
The experiences of the Baltic states show that
large-scale internal devaluation is both economically possible and desirable,
in terms of returning to economic growth. However, the Baltics’ adjustment was
preceded by very rapid GDP growth. Significant contraction in wages and GDP had
less perceived effect since the population had yet to consider the pre-crisis standard
of living as the norm… Crucially all other existing
currency unions also rely on a common fiscal backstop, therefore although internal
devaluation is necessary it is alone unlikely to be sufficient to solve the
eurozone crisis.
17-May-2013 The periphery's problem is an incomplete internal devaluation – The
Economist
An “internal devaluation” and a “true devaluation” are different. Both
address flow but only a “true devaluation” adjusts stock. Consider a
counter-factual, where Spain had remained in
Stage 2 of EMU (ie in the ERM, not the euro) and had realigned 30%, rather than
“internally devalued”. The effect on flow accounts such as wage costs would be
the same, but not on the stock.
With current policies failing to address internal and external balance
requirements, the combination of prices and wages policies and overt money
financing of budget deficits would provide a policy mix that would greatly
improve the economic prospects of troubled European countries.