Fourth Post on Europe: A Refinement

In my previous post I laid out a fairly crazy idea for internal devaluation in a country that does not control its currency (for instance, because it is part of a currency union such as the euro).  In this post I'll make a few more observations.  Since I am not an economist, you should take all of this avec un gros grain de sel.

Recall that the idea is for the government to adjust the wages of all workers simultaneously so as to achieve a rapid, one-shot deflation that restores the balance of payments.  The idea is that ordinarily prices are so sticky that it takes massive unemployment to attain sufficient deflation.  Moreover, the prospect of years of deflation induces people to hold cash rather than engage in economic activity.  If prices are forced downward by a large percentage, they will then start rising again, which will constitute inflation and which will induce people to spend their money.

But consider the way people will behave prior to this massive, one-shot deflation.  Holding cash will be an amazing investment, because it may appreciate several percentage points over the span of a few months—an enviable rate of return.  So as long as people anticipate that the one-shot deflation may be coming soon, economic activity will be suppressed as people hoard cash.  This could be a big problem.  I think it means that you would want to do it quickly and finally, with no possibility of further downward adjustments to the government coefficient for the next several years.  And it might make sense to err on the side of going too far, which is somewhat counterintuitive but which ensures that immediately after the deflation everyone will expect prices to rise.  If you expect prices to rise, your incentive is to spend sooner rather than later.  This, along with the improvement in the tradeable goods sector, should boost aggregate demand.  (But who knows, you still have to deal with the fact that workers are earning less and will be reluctant or even unable to spend.)

In that regard, it would probably make sense to encourage businesses to cut prices on the day the coefficient is adjusted.  If wages are being slashed 10%, then businesses should be able to cut their prices by 7 or 8%, which will greatly alleviate the burden of lower wages.  And of course this is the whole point, not just to make labor cheap but to effectuate a broad-based drop in prices throughout the economy.  The only businesses that should not be expected to drop prices should be sellers of imports.  Their costs should not be falling much, whereas most businesses should enjoy (A) a huge drop in wage costs and (B) a drop in input prices as other businesses slash their prices.

But I am still worried about the way people will behave in anticipation that the policy will be triggered.  I am also worried that the government might not cut deeply enough, leaving prices above equilibrium and leaving some amount of deflation to be accomplished by grinding unemployment.

Finally, note that this policy seems as though it would work best for a small, trade-oriented country like the Netherlands (which I imagine doesn't need internal devaluation) or Ireland (which probably does).  It seems well-suited for Europe, which is generally made up of a quilt of small countries with highly interlocking economies.  It is probably not so well-suited for a country like the U.S., which does not really trade very much relative to its GDP.  But of course, the U.S. has its own currency and should never need to do anything like what I am proposing.