Will internal devaluation work?

My friend Rob Parenteau doesn’t think it will. His argument against it is similar to the one I have been making about the origins of this crisis. Here’s what I said.

I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that. More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.

And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken. The question still up for debate is regarding systemic risk, contagion, and economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.

Rob puts why internal devaluation is not a plausible strategy differently. Here’s the flow of his argument.

  1. Many nations try internal devaluation at the same time;
  2. Private sectors have debt to income ratios that well exceed public debt to income ratios;
  3. Credit to households to supplement buying power (in excess of wage and salary) is unlikely to be forthcoming given the mess in the banking system and the falling price of (real estate and equity) collateral;
  4. Many nations are pursuing multiyear fiscal consolidation, which is proving far from expansionary to date;
  5. Many countries around the world are already trying to run export led growth strategies, and not only is it impossible for the whole world to run a current account surplus, but there is no market or policy mechanism insuring that the current account surplus nations reinvest their net savings in productive investments in the current account deficit nations that will allow the current account deficit nations to service their external liabilities without defaulting.

Rob encouraged me to re-read Chapter 19 of Keynes’ General Theory, saying

“We know these deflationist arguments inside out. We know why lowering wages is unlikely to introduce a self-stabilizing return to a full employment growth path.”

I skimmed through Chapter 19 on “Changes in Money-Wages” as Rob suggested. Here’s the quote that bears remembering:

“the volume of employment is uniquely correlated with the volume of effective demand measured in wage-units, and that the effective demand, being the sum of the expected consumption and the expected investment cannot change, if the propensity to consume, the schedule of marginal efficiency of capital and the rate of interest are all unchanged. If, without any change in these factors, the entrepreneurs were to increase employment as a whole, their proceeds will necessarily fall short of their supply-price.”

Yes, that is where I was going with my thoughts yesterday on manufacturing inflation in a wage deflationary environment. I said that “until incomes rise enough to support the debt (numerator) or you get enough credit writedowns so that incomes support the debt (denominator), it’s not going to work.” What I meant was that we have household sector balance sheet problems. Unless you fix the debt/income number instead of the debt/GDP number, the balance sheet problem remains. Eroding the real burden of debt is dependent not on raising nominal GDP, but on raising nominal income to keep pace with consumer price inflation. A lot of economists are talking about ‘market-clearing’ wage prices, that is lowering incomes, to reduce unemployment. That will make the debt problem larger and leads to a debt deflationary outcome.

Bottom line: you won’t cut your way to prosperity. While you need to see a lot more credit writedowns to get through this crisis, the best one can hope for from the deflationary path is a reduction in debt from these defaults and writedowns with debt deflation attenuated by automatic stabilizers. This outlook is especially true when you see a collective debt reduction across a wide swathe of countries in both public and private sectors as we saw in the 1930s and as we are seeing again today.

  1. fresno dan says

    “Eroding the real burden of debt is dependent not on raising nominal GDP, but on raising nominal income to keep pace with consumer price inflation”
    I believe you!
    The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

    Part of the problem, IMHO, is that the regulatory foundation (including congress, Basil, rating agencies – there is a lot of blame) of overseeing the financial industry bought hook, line, and sinker what they had to say. Now we are entirely in this mess due to the finance industry, and by proxy, the failure of, though not exclusively, the FED to see and understand what was going on. And once your house burns down, there is a loss and there is pain. But good grief, stop storing gasoline next to the stove!
    There seems to be a bizarre belief that no bank can fail(its a profit and loss system!) I can actually agree that there are institutions TBTF (and TBTF means TOO BIT TO EXIST) – but there should be NO management that is TOO BIG TOO FIRE. To me, the simpliest and most effective way to counteract the shennaigans of the finance industry would be to have this explicit deal – need a government bailout and the CEO, CFO, and 2 or 3 other top managers, and board are all fired, and lose ALL compensation of the last three years. (of course, our system believes that the fire starters at AIG were necessary to keep….cause they know how to unburn down a house?)

  2. fresno dan says

    forgive my excesswive commentary, but just to back up my point about the FED, here is another FEd speeck I stumbled across:


    Timmy Geithner:
    These concerns have been heightened in some quarters by the problems currently being experienced in the subprime mortgage sector. It will take some time before the full implications are understood and the full impact can be assessed. As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole.

    Indeed, economic theory and recent practical experience offer some reassurance against both these specific concerns and more general worries about the implications of credit market innovations for the performance of the financial system.

  3. Philip Pilkington says

    Yes. Other reasons internal devaluation won’t work:

    From Chapter 19 of Keynes: If you reduce wages et all, then tax revenues will fall further exacerbating public debt-to-GDP ratios (because income taxes and VATs will fall). If the object is to bring these public debt-to-GDP ratios down this is a paradoxical strategy.

    From a conversation between me and Rob (!): We must assume quite a lot of price stickiness in consumption driven economies like Ireland etc. Businesses will defend prices even at the expense of layoffs. So, when (if?) wages fall the price stickiness will lead to pro-cyclical effects (more unemployment, lower wages etc.). Hence: downward spiral.

    1. Edward Harrison says

      I’ll have to ping Rob again and see if he can flesh out his bullet points and incorporate some of that. Thanks.

      1. Philip Pilkington says

        Forward you the correspondence now. See what you can do with it. You should try to get Rob to do a full piece on this. I’m sure Yves would run it too.


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