Arnold Kling  

The Magic Solution of Devaluation

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Scott Sumner writes,

If the Spanish and Greek governments shrank enough to balance their budgets, they'd still have 24% unemployment, if not more. Their economies are hopelessly uncompetitive at the current exchange rate.

And if those countries had a huge currency devaluation, what would the unemployment rates look like? My guess: still more than 20 percent.

Devaluation causes huge problems for companies with debts denominated in foreign currency. It also has other large redistribution effects. To me, it seems plausible that the redistribution effects of a devaluation will, on net, be damaging to patterns of specialization and trade.

Scott believes so strongly in the sticky-wage model of unemployment that he is convinced that a devaluation would work wonders, because it would reduce wages in Spain or Greece relative to wages in other countries. I don't begrudge Scott for believing that the sticky-wage effect is a very significant driver of unemployment and that debasing the currency is a neat, effective way for dealing with it. But those of us who are skeptical of that model are not necessarily fools.

[update: Martin Feldstein writes,

The declining value of the euro holds the key to the eurozone's survival.

Again, do not be so sure.]

COMMENTS (9 to date)
Vincent Davis writes:

Obviously it is complicated and there are different companies with different mixes of import, export, foreign and domestic debt.
Also it is not that a specific working is nessasarily unproductive at there job but rather that ( not sure how to say this) they are not competitive when considering the full economy/regulation/government.....
My question, how does the devaluation differ from making transparent the uncompetitive economy? It is not clear to me that devaluation would do more than make it clear how difficult it would be for the company in your example to repay a foreign denominated loan. Does it actually make it more difficult.
I am assuming free trade and easy labor movement within the euro zone.

MikeDC writes:

A simple question for Sumner and other supporters of devaluation:

At what exchange rate would the Spanish and Greek economies become competitive?

Just like the question of "what is the optimal NGDP target" proponents of devaluation present messing with the exchange rates as if it's an easy, empirical matter. But in reality, I've never seen much time or rigorous study put into the seemingly obvious question of what the "right" answer is.

My guess is such an answer would drive home the point that there'd still be 24% unemployment if exchange rates were allowed to float.

The rapid devaluation would, I guess, demolish Greek expectations and force them to "go back to work" in the same way that the folks in Yglesias' poor town have to go back to work after discovering their $1M checks are all fraudulent. But in doing so, it'd seem to cause just as much havoc as democratically concluding that they're all spending too much on the government they receive.

The only difference I can tell is that the devaluation process is, effectively, a way for bureaucrats to force this sort of change. While cutting the government via the democratic process (such as it is in those countries) is difficult and requires painful recognition of broken promises and reality. The sort of things politicians don't like doing.

Costard writes:

That Greece can return to the drachma and devalue it seems beyond question. The idea that this devaluation could be controlled is laughable. Monetary policy requires not currency but money, and I've yet to see any indication that Sumner understands the difference.

JVDeLong writes:

During the 1930s, wasn't the idea that a nation could gain by devaluing and thus improving its export situation called "beggar thy neighbor", and scorned on the ground that it would lead to continuing rounds of competitive devaluation? What has changed?

Lorenzo from Oz writes:

The Australian experience is that, while economic reform is very important, yes, exchange rate shifts CAN allow your economy to keep going through a major economic shock.

The more flexible your economy, likely the smaller the devaluation required; and yes, it affects your debt levels for debts denominated in foreign currencies. But, being able to actually sell (much more) stuff makes a big difference.

Gary Rogers writes:

Does it strike anyone as odd that the Germans can be competitive with the same exchange rate? Maybe currency value is not the problem.

Mike F writes:

In the case of Spain and Greece, devaluation would have immediate and large gains for some of their principal industries...tourism and vacation/retirement properties.

Blackadder writes:

And if those countries had a huge currency devaluation, what would the unemployment rates look like? My guess: still more than 20 percent.

What is the unemployment rate in Iceland?

Michael Rulle writes:

Certainly a sudden devaluation today, would not have much of a positive impact. But it very easy to believe some countries are more competitive than others. These countries are not one entity as thousands have said before. The Euro was an "idealistic" concept to create a Euro state. Lets use price as a signal. What was the price signal that warned us off from Greece relative to Germany? Perhaps its bond rates? Not by much. Certainly not its exchange rate.

False signals were given. If true exchange rates prevailed, Greece probably would not have drifted off as far as it did.

A Greek cannot easily become a German.(Can they at all?). A Mississippian, on the other hand, can easily become a New Yorker if they so choose.

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