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 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.