Internal Devaluation ?!?

Beginner’s question:
I was reading Krugman’s long article on how the Euro allowed weak countries to borrow on the same easy terms as strong countries — leading to the usual (e.g., Irish) bankers lending excess monies to people who can’t pay back. The usual cure — if a country has its own currency — is to devalue in order to pay back in cheaper currency and encourage export growth (I think). Somehow the equivalent of this — if you don’t have your own currency — is supposed to be to cut wages.

How does cutting wages help pay back your country’s debts?

This is a big hangup to me as a big prolabor guy. I’m thinking America (not Europe) can get going again by paying people more — 15% of income having shifted from the bottom 90% who would definintely spend it to the top 3%, mostly top 1%, who wont spend it and have nothing healthy to invest it in given lack of demand in a recession (not to mention lack of demand from people who should have gotten the income in the first place!). I don’t like the idea of cutting European wages either

My answer after the jump.

Let’s do America. One way in which we could pay our debts is if the dollar declined in value. That should cause increased exports and reduced imports so we would run a trade surplus. If that surplus was greater than the amount we have to pay our foreign creditors minus the income on our foreign assets, we would have a current account surplus so our debt would shrink (we would have a capital account deficit).

Strange but true, the US current account deficit is simiilar to our trade deficit. Even though on paper we are huge debtors (biggest evar) our foreign assets pay a much higher rate of return than our debts to foreigners.

But if Ireland uses Euros so it can’t devalue. Or can it. What if all wages, prices and rents in ireland were cut in half ? The effect would be the same as if they still had Irish Punts which devalued 50% against the Euro — foreign goods and services would suddenly cost twice as much compared to Irish goods and services.

The balanced decline in wages and prices (including rents) is called an internal devaluation. In the real world, it is very slow and painful process.

Part of the trick was that, in the case of devaluation of the dollar (or punt) I assumed that both the prices of domestically made goods and nominal wages stayed the same. In the real world, firms by foreign made materials, so their costs (in dollars) increase. When discussing devaluation, I assumed that firms produce using only capital and labor so if wages, the price of the capital and the interest rate don’t change, then costs don’t change. Trade was modelled only as trade in finished goods.

So it is hard to say how prices should change in order to mimic the effects of a devaluation. Also economists often assume that prices automatically adjust to equal marginal cost (perfect competition — a clearly false assumption made for convenience) or a multiple of marginal costs (fixed markups again a clearly false assumptino made for convenience and often made by Krugman).

Given either of these comforting fantasies, the instruction “cut wages and prices to make everything change just as it would with a devaluation and no I don’t know how much the price of that banana should be cut” becomes “cut wages and prices will take care of themeselves.”