Blog Post

Devaluation and internal adjustment of the real exchange rate

There is an interesting debate at Free exchange of Economist.com on real exchange rate adjustment. The author of the article brought the point that while devaluation is painful and amid crisis can contribute to and is often associated with significant economic contraction, it helps to achieve a fast V-shaped recovery in output. Without devaluation the […]

By: Date: July 15, 2012 Topic: Macroeconomic policy

There is an interesting debate at Free exchange of Economist.com on real exchange rate adjustment. The author of the article brought the point that while devaluation is painful and amid crisis can contribute to and is often associated with significant economic contraction, it helps to achieve a fast V-shaped recovery in output. Without devaluation the adjustment path is slower and more painful. Joseph Gagnon added further points by arguing that there are even examples in which devaluation (resulted from the sudden stop in capital inflows) is not associated with economic contractions. Poor outcomes after devaluation, he argues, is the result of poor (inflation generating) policies and not devaluation, but when devaluation is caused by rising unemployment or external deficits, the outcome used to be more benign. These two introductory pieces received many insightful comments worth reading.

How does Bruegel research relate to these points – to which I happened to contribute?

In a December 2011 paper comparing Iceland, Ireland and Latvia I found that the policy mix of Iceland, which included devaluation, capital controls, bank defaults and reorganization, and fiscal consolidation led to the smallest fall in employment, despite the greatest shock to the financial system. Latvian authorities decided to keep the exchange rate peg, which has likely contributed to Latvia’s dramatic hit, which was harder than in any other country of the world. And Ireland, a euro-area member, also suffered heavily. Yet the recovery in Latvia also seems to be V-shaped, which is good news – but one has to add that after losing one quarter of GDP a fast recovery is not unexpected, as I already argued in 2009 the main challenge is medium term growth. Output and employment (even when considering the business sector excluding construction, real estate activities and agriculture) are still more than 10 percent below the pre-crisis peaks.

In a recent paper I looked at labour cost and productivity adjustment of 24 EU countries in detail. The so called “internal adjustment” of the real exchange rate, i.e. productivity improvements and wage cuts to restore price competitiveness, did work in some cases (Ireland, Spain, Latvia and Lithuania) and the export performance of these countries is also among the best, which is good news. Eg Spanish exports over-performed German exports from 2008Q1 to 2011Q4. But labour market outcomes were dramatic. Private sector wages have declined to some extent, but the wage falls have corrected just a small fraction of pre-crisis wage rises, they were accompanied by massive employment losses, and they were temporary and were largely or even fully reversed by the end of 2011 (see detailed charts for all 24 EU countries here). And for euro-area members the economic outlook is bleak – certainly, not just due to the lack of devaluation. A small good news is that the euro, which has been too strong for too long, started to depreciate somewhat, which should help both euro-area core and periphery countries, yet its current rate against the US dollar (about 1.22) is still very far from the historical lows of about 0.85 in 2000-2001.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article
 

Blog Post

European governance

Germany’s post-pandemic current account surplus

The pandemic has increased the net lending position of the German corporate sector. By incentivising private investment, policymakers could trigger a virtuous cycle of increasing wages, decreasing corporate net lending, which would eventually lead to a reduction of the economy-wide current account surplus.

By: Lionel Guetta-Jeanrenaud and Guntram B. Wolff Topic: European governance, Macroeconomic policy Date: October 21, 2021
Read about event
 

Past Event

Past Event

Monetary policy in the time of climate change

How does climate change influence monetary policy in the eurozone? What potential monetary policy measures should be taken up to address climate risks?

Speakers: Cornelia Holthausen, Jean Pisani-Ferry and Guntram B. Wolff Topic: Green economy, Macroeconomic policy Date: October 20, 2021
Read article More by this author
 

Podcast

Podcast

Rethinking fiscal policy

A look at the past, present and future of fiscal policy in the European Union with Chief economist of the European Stability Mechanism, Rolf Strauch.

By: The Sound of Economics Topic: European governance, Macroeconomic policy Date: October 20, 2021
Read about event More on this topic
 

Upcoming Event

Nov
4
14:00

European monetary policy: lessons from the past two decades

This event will feature the presentation of “Monetary Policy in Times of Crisis – A Tale of Two Decades of the European Central Bank."

Speakers: Grégory Claeys and Wolfgang Lemke Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article
 

External Publication

European Parliament

Tailoring prudential policy to bank size: the application of proportionality in the US and euro area

In-depth analysis prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Alexander Lehmann and Nicolas Véron Topic: Banking and capital markets, European Parliament, Macroeconomic policy Date: October 14, 2021
Read article More by this author
 

External Publication

Global Economic Resilience: Building Forward Better

A roadmap for systemic economic reform calling for step-change in global economic governance to increase resilience and build forward better from economic shocks, prepared for the G7 Advisory Panel on Economic Resilience.

By: Thomas Wieser Topic: Global economy and trade, Macroeconomic policy Date: October 14, 2021
Read article More on this topic More by this author
 

Opinion

Letter: Declining investment may explain why rates are low

Perhaps an analysis of the causes of the declining investment rate would bring us closer to explaining why real interest rates are so low.

By: Marek Dabrowski Topic: Macroeconomic policy Date: October 1, 2021
Read article More by this author
 

Podcast

Podcast

A green fiscal pact

How can the European Union increase green public investment while consolidating budget deficits?

By: The Sound of Economics Topic: European governance, Macroeconomic policy Date: September 29, 2021
Read article More on this topic More by this author
 

Blog Post

Monetary arithmetic and inflation risk

Between 2007 and 2020, the balance sheets of the European Central Bank, the Bank of Japan, and the Fed have all increased about sevenfold. But inflation stayed low throughout the 2010s. This was possible due to decreasing money velocity and the money multiplier. However, a continuation of asset purchasing programs by central banks involves the risk of higher inflation and fiscal dominance.

By: Marek Dabrowski Topic: Macroeconomic policy Date: September 28, 2021
Read article More on this topic More by this author
 

Opinion

The pandemic’s uncertain impact on productivity

The pandemic has certainly permanently affected our way of working. Whether this is for the better remains to be seen.

By: Maria Demertzis Topic: Macroeconomic policy Date: September 28, 2021
Read about event More on this topic
 

Past Event

Past Event

How to strike the right balance between the three pillars of the pension system?

In this event panelists will discuss the future of European pension schemes.

Speakers: Elsa Fornero, Svend E. Hougaard Jensen and Suvi-Anne Siimes Topic: Macroeconomic policy Date: September 23, 2021
Read article More on this topic More by this author
 

Blog Post

Germany’s foreign economic policy: four essential steps

Germany and the EU need to develop a strong and proactive agenda to manage foreign economic relations, which are essential for German and European prosperity.

By: Guntram B. Wolff Topic: Macroeconomic policy Date: September 23, 2021
Load more posts