In a world of free capital movements, implementing prevention measures raises other issues. First, it requires international coordination, which is the chief reason why a banking union is far more imperative than a fiscal union for the survival of the eurozone.
Second, it would be desirable for systemic central banks – the U.S. Federal Reserve and to some extent, the European Central Bank – to take into account the international repercussions of their policies.
Let us start with the recession. Banks need to fix their damaged balance sheets, which usually leads to a credit crunch that impacts aggregate demand (AD): less investment because of a lack of credit, less consumption due to lower employment and the burden of household debt, and worsening expectations. This scenario prompts a negative feedback loop that intensifies as time goes on.
Higher government spending can slow the momentum toward depression, at least temporarily. Austerity policies, or fiscal contractions, may be inevitable, but they will definitely hinder growth in the short run. Growth-friendly austerity policies do not exist, and should not be confused with prudent fiscal management under full employment conditions.
The alternative is to boost foreign demand by stimulating exports. A small, open economy will do this by devaluing its currency. Members of the eurozone do not have this option, but perhaps lowering domestic prices would have the same effect.
Nonetheless, there is an essential difference between these two types of devaluation: a conventional devaluation will increase demand for exports without impacting domestic aggregate demand. Since nationals have become poorer only in relation to foreign goods, it can be assumed that the total effect on aggregate demand will be positive.
On the other hand, an internal devaluation implies lower wages, which impoverishes domestic workers and consequently decreases consumption. This effect is amplified if the decline in wages is achieved at the expense of higher unemployment. Whether or not a drop in domestic spending is offset by potentially higher exports is an open question. If the answer is negative, the internal devaluation is counterproductive. Furthermore, other factors must be considered before advocating an internal devaluation.
First, when discussing trade between countries, comparative advantage is the proper standard, not the red herring of “competitiveness.” Hence, the customary practice of using aggregate data on unit labor costs (ULCs) fails to provide the full picture: a decomposition of aggregate exports into sectors is the proper basis for inter-country comparisons of “competitiveness.”
Second, an internal devaluation is more effective when both wages and prices fall, since real wages – and consequently, domestic consumption – decrease less than in the wage-only case. Additionally, it is most effective when monetary policy can react to lower prices by reducing the policy interest rate (a monetary expansion), as Jordi Galí and Tommaso Monacelli contend.
The case of Spain
These combined factors give us reason to suspect that an internal devaluation was unnecessary in the case of Spain: the loss of competitiveness was exaggerated, it was a wage-only devaluation, and the behavior of exports during the crisis seemed to have had minimal impact on price changes.
When it comes to mitigating the impact of a financial crisis on aggregate demand, the aforementioned analyses point to the following conclusions: implement a strategy of fiscal expansion, avoid fiscal contractions and regard alternative measures with caution.
The stock problem is the “mountain of debt” that financial crises leave in their wake. A large volume of debt relative to the income flow of the debtor, whether public or private, constricts spending. To the extent that recessions stem from a deficiency in AD, excessive debt aggravates the situation and slows down economic recovery. The failure to properly address debt in the ongoing crisis in the eurozone amply demonstrates this.
One thing, however, is clear: austerity, while commendable at the individual level, is detrimental at the aggregate level since it hinders growth.
The debt problem has thus far been left unresolved, although, as Carmen Reinhart and Kenneth Rogoff have indicated, past crises generally prompted some sort of debt relief. Slow growth – both in terms of population and productivity – and mounting pressure to expand public services like health care and higher pensions only add to the problem.
The launch of the euro was probably premature, but the lack of real convergence was not the root of the crisis: excessive indebtedness was. Moreover, the nature of debt is important: in the case of private debt, the creditor takes the hit, whereas default on bank debt – the main instrument used in Europe – puts the entire financial system at risk.
Critics of the euro have been very vocal in expressing their belief that a fiscal union must accompany a monetary union. Nonetheless, the U.S. had a single currency long before a fiscal union was in place. Moreover, federal transfers, even today, are very limited in amount. Debt ceilings would have lessened the impact of the crisis in some of the peripheral countries without putting the euro at risk.
The current crisis has taught us some valuable lessons. At its core, the crisis illustrates the need to disregard age-old principles. Unfortunately, creditors’ dogged adherence to some longstanding doctrines has led to misconceived policies, inflicting unnecessary pain on some without putting an end to the crisis. For some, the question of whether recovery will come soon enough is still up in the air.