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Why Internal Devaluation Is Advantageous

by | June 6th, 2012 | 10:00 am

Internal devaluation has become a big issue in the euro area but it remains controversial. In the latest International Monetary Fund (IMF) letter of intent for Greece, box 3 on “Internal Experience with Internal Devaluation” (pp. 48–49) opposing internal devaluation has been incorporated. It summarizes the standard arguments, but the point of this comment is to show that they are all flawed.

The meaning of internal devaluation is to carry out real effective exchange rate depreciation without nominal devaluation. This can be done by several means—direct cuts of wages and public expenditures but also manifold structural reforms that render the economy more efficient.

The bottom line of this IMF box runs: “Internal devaluations are almost inevitably associated with deep and drawn-out recessions, because fixed exchange rate regimes put the brunt of the adjustment burden on growth, income, and employment” (IMF 2012, p. 48).

The tentative proof of this thesis is the cumulative output loss from the pre-recession peak in the ensuing three and a half years in four countries—Argentina, Greece, Hong Kong, and Latvia. It is difficult to compose a more disparate group of countries. First, since this comparison does not control for any preconditions, it is of little or no empirical value.

Second, this is too short a period for assessing any major economic event as the crises in Argentina, Greece, and Latvia (but not in Hong Kong) were. One should look at least at a decade and preferably at two decades, because what is really of interest is the future growth trajectory.

Third, an analysis must also consider the prior growth rate. A frequent argument is that Argentina shows the benefits of devaluation because of the long and rapid growth afterwards, but we should not forget what happened before the crisis. While Argentina enjoyed decent growth, Latvia thrived on an astounding boom. As a consequence during the corresponding periods 2000–2011 and 1992–2003, Latvia had a cumulative growth of 51 percent and Argentina only 15 percent (figure 1).

Finally, at the onset of crisis in Latvia, the IMF (2009, p. 5) staff assessed that Latvian “output exceeded potential by 9 percent in 2007,” so output had to contract. Thus, for a fair comparison, we should deduct 9 percentage points from the Latvian output decline, which would reduce its cumulative output fall from 24 percent to 15 percent. Darvas (2011) makes all these four mistakes as well.

A second contention of the IMF box is: “Restoring competitiveness by way of internal devaluation has proved to be a difficult undertaking with very few successes” (IMF 2012, p. 48). In this case, the box offers no example, which may be just as well, because this is a very dubious statement. It is sufficient to point to Europe in the last three decades. Denmark pegged its krone to the Deutschmark in 1982 to achieve more structural reform and cost control, what we now call internal devaluation, and it succeeded. In 1987–89, Holland did the same with similar success. So did Germany in the early 2000s, and all three Baltic countries as well as Bulgaria did so in 2008–10. Thus, contrary to the unverified IMF statement, internal devaluation has probably been the most successful reform strategy in Northern Europe. It is a different matter that severe crises are always difficult to resolve. When big adjustments are necessary, the social cost becomes substantial regardless of the solution.

A third IMF claim is: “Country experience suggests several factors are needed for internal devaluation to work. The most important preconditions are an open economy with high factor mobility and a high degree of wage and price flexibility” (IMF 2012, p. 48). But this puts the cart before the horse. These were the very aims of the internal devaluation in Denmark, Holland, and Germany and they proved successful.

Fourth, the IMF box insists: “…real effective exchange rate [REER] depreciations have been regularly only modest due to only limited pass-through to prices (Baltic states, Argentina, and Greece)” (IMF 2012, p. 49). This statement is incorrect. All the three Baltic states have shown significant improvements in REER of 18 percent for Latvia, 8 percent for Lithuania, and 5 percent for Estonia from 2008 to 2010 (figure 2), and Argentina and Greece were no reformers.

Fifth, the IMF claims “it also takes a long time for resources to shift from the non-tradable to the tradable sector, and both persistent skill mismatches and lack of increased investment in the tradable sector preclude full factor reallocation (former East Germany, Latvia)” (IMF 2012, 49). This is another flawed assertion because East Germany offers no such proof. With massive subsidies amounting to as much as half of East Germany’s GDP, an average of $80 billion a year for two decades, West Germany tried to slow down structural adjustment, notably migration in East Germany, which suffered from seeing no internal devaluation (Åslund 2007, pp. 92–93, 285–86). Latvia, and the other Baltic countries, on the contrary, have seen a stunning expansion of exports and manufacturing after the crisis that not even the greatest optimists predicted. Estonia and Lithuania experienced a peak annualized export growth of 45 percent in the first quarter of 2011 (figure 3). Greater expansion is hardly healthy.

Sixth, “External adjustment therefore works predominantly through import compression rather than an expansion of exports….”(IMF 2012, p. 49). This is actually partially true. The Baltic imports plummeted in mid-2008 and exports started soaring only in early 2010, but that is quite a limited period. This is hardly a concern.

Finally, the IMF box authors claim: “The experience of Argentina in 1998–2002 shows that an economy can get trapped in a downward spiral in which adjustment through internal devaluation eventually proves impossible, and the only way to an eventual recovery remains default and the abandoning of the exchange rate peg” (IMF 2012, p. 49). Well, bad policy breeds bad results. Any claim that Argentina pursued a sound policy of internal devaluation as the seven European countries mentioned above falls flat, which Michael Mussa (2002) showed so eloquently. Similarly, Greece has started off with similarly soft policy adjustment, based more on tax hikes than expenditure cuts, which has led to the expected poor results, but that is not a reason to make even worse mistakes. One decade after its famous devaluation Argentina is hardly pursuing economic policies that anybody would advise others to follow, which is one reflection of its failure.

A major conclusion by the IMF is that nominal devaluation has neither been necessary nor beneficial for the regaining of competitiveness. On the contrary, if a country maintains a fixed exchange rate, it is forced to undertake more structural reform, and is more likely to do so. Fixed exchange rates prompted the greatest fiscal and structural adjustments in Central and Eastern Europe.

The crisis resolution of Latvia has proven that internal devaluation is a viable option and perhaps even advantageous. The fixed exchange rates did not impede adjustment but on the contrary facilitated radical adjustment. This applies also to the members of the EMU. Indeed, the role of exchange rate regimes seems to be overemphasized. Maurice Obstfeld and Kenneth Rogoff (2001, p. 373) pointed out “the exceedingly weak relationship between the exchange rate and virtually any macroeconomic aggregates.” Other policies are simply more important. Therefore, the need even for major cost adjustment is not a reason to leave the euro area.

Note: Natalia Aivazova has kindly provided me with excellent research assistance.


Åslund, Anders. 2007. How Capitalism Was Built: The Transformation of Central and Eastern Europe, Russia, and Central Asia. New York: Cambridge University Press.

Åslund, Anders, and Valdis Dombrovskis. 2011. How Latvia Came out of the Financial Crisis. Washington: Peterson Institute for International Economics.

Calvo, Guillermo A. 1998. Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops. Journal of Applied Economics 1, no. 1: 35–54.

Darvas, Zsolt. 2011. A Tale of Three Countries: Recovery after Banking Crisis. Bruegel Policy Brief 19. Brussels: Bruegel.

Dornbusch, Rudiger, Ilan Goldfajn, and Rodrigo O. Valdés. 1995. Currency Crises and Collapses. Brookings Papers on Economic Activity 26, no. 2: 219–293.

IMF (International Monetary Fund). 2009. Republic of Latvia: Request for Stand-By Arrangement—Staff Report. Country Report No. 09/3. Washington.

IMF (International Monetary Fund). 2012. Request for Extended Arrangement Under the Extended Fund Facility—Staff Report. Country Report No. 12/57. Washington.

Mussa, Michael. 2002. Argentina and the Fund: From Triumph to Tragedy. Washington: Institute for International Economics.

Obstfeld, Maurice, and Kenneth S. Rogoff. 2001. The Six Major Puzzles in International Macroeconomics: Is There a Common Cause? In NBER macroeconomics Annual 2000, eds. Ben S. Bernanke and Kenneth S. Rogoff, Cambridge: MIT Press, pp. 339–390.

Williamson, John. 1995. What Role for Currency Boards? Washington: Institute for International Economics

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