"Talk of internal depreciation is faulty"

"If the PIIGS could reduce prices and wages by 5% per year for five years, you would get the necessary cumulative compound fall of 30% in nominal prices/wages to restore competitiveness.

The problem with the deflation route to a real depreciation is twofold. First, deflation is associated with persistent recession and no social or political body could accept another five years of recession to reduce prices/wages by 30%; Argentina tried the deflation route to a real depreciation, but after three years of an ever-deepening recession gave up and decided to default and exit its currency board peg. Second, even if by some miracle deflation was feasible and successful, the real value of the already-high private and public debts would rise sharply (a balance-sheet effect), forcing even-larger defaults and debt reductions.

All the talk by the ECB and the EU of an “internal depreciation” is thus faulty: Even the often-heard argument that reducing public salaries would lead to a rapid real depreciation is erroneous as it would require private wages and prices to fall accordingly and would not prevent the damaging balance-sheet effects.

The alleged case of a successful internal devaluation—that of Latvia—is not relevant here: Entering the crisis, its public debt was 9% of GDP,...; losses from depression and deflation were taken by foreign banks dominating its banking system; and accepting a draconian 20% fall in output was politically feasible as Latvia did not want to fall into the harms of the Russian bear again.

And let us not forget that the necessary fiscal austerity has—in the short run—a negative effect on economic growth; thus, it postpones the recovery of growth that is necessary to make the reforms and austerity socially and politically feasible; and that is also necessary to make the debt and deficit ratios sustainable (as falling GDP increases those ratios, despite fiscal austerity efforts).

If the euro is not going to fall sharply, if reducing unit labor cost takes too long to restore competitiveness and growth and if deflation is unfeasible or (if achieved) self-defeating, there is only one other way for the PIIGS to restore competitiveness and growth: Leave the monetary union, go back to national currencies and thus achieve a massive nominal and real depreciation. After all, in all emerging market financial crises where growth was restored, a move to flexible exchange rates was necessary and unavoidable on top of official liquidity, austerity and reform and, in some cases, debt restructuring and reduction."