The Magic Solution of Devaluation
If the Spanish and Greek governments shrank enough to balance their budgets, they’d still have 24% unemployment, if not more. Their economies are hopelessly uncompetitive at the current exchange rate.
And if those countries had a huge currency devaluation, what would the unemployment rates look like? My guess: still more than 20 percent.
Devaluation causes huge problems for companies with debts denominated in foreign currency. It also has other large redistribution effects. To me, it seems plausible that the redistribution effects of a devaluation will, on net, be damaging to patterns of specialization and trade.
Scott believes so strongly in the sticky-wage model of unemployment that he is convinced that a devaluation would work wonders, because it would reduce wages in Spain or Greece relative to wages in other countries. I don’t begrudge Scott for believing that the sticky-wage effect is a very significant driver of unemployment and that debasing the currency is a neat, effective way for dealing with it. But those of us who are skeptical of that model are not necessarily fools.
[update: Martin Feldstein writes,
The declining value of the euro holds the key to the eurozone’s survival.
Again, do not be so sure.]