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Devaluation pros and cons

By Kevin O’Rourke
Kevin O’Rourke is Professor of Economics at trinity College Dublin
Thursday February 26 2009

…The textbook solution is for governments to tackle their fiscal problems by raising taxes and cutting expenditure, and to simultaneously tackle their unemployment problems by devaluing their currency. Devaluation is essentially a confidence trick, and — although some economists are reluctant to admit it — it works.

It works by cutting workers’ wages, not by reducing the amount they see on their pay stub every week or month, but by making the currency they are being paid in less valuable. The result is less expensive labour, and therefore more employment.


If devaluation is not possible, what are the alternatives? Theory identifies three. First, unemployed workers can emigrate to countries where there are jobs. This adjustment mechanism has historically been very important in dealing with the consequences of regional booms and busts in the United States.

Second, the state can receive fiscal transfers from abroad. At the time of the debate about EMU, a widely cited estimate had it that when an individual state in the US suffered an income loss of one dollar, nearly 40c of that loss was absorbed by the fact that it paid fewer taxes to, and received extra transfers from, Washington DC.

Third, wages can fall to the level where firms are willing to hire all available workers. Of course, if wages are this flexible, then unemployment will not be a problem in the first place.  As we can see today, it is difficult to cut nominal wages across an economy (but less difficult in individual companies where workers can see that their jobs are on the line).

So why are most economists against the idea of quitting the euro and devaluing our own currency?…Link to article

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