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.
- Many nations try internal devaluation at the same time;
- Private sectors have debt to income ratios that well exceed public debt to income ratios;
- 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;
- Many nations are pursuing multiyear fiscal consolidation, which is proving far from expansionary to date;
- 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.