09 March 2013

Sinn & Valentinyi: European imbalances

Overall, given that policymakers have excluded the option of exit, economic policymaking must focus on the possibilities for internal devaluations, despite some of the difficulties it may bring.

Europe is in the grip of three interrelated crises: a balance of payments crisis, a sovereign debt crisis and a banking crisis. Policymakers have primarily focused on the sovereign debt and banking crises. However, a credible strategy for getting the eurozone back on track needs to address the problem of its large internal imbalances. Rebalancing will require countries with current account deficits to devalue. The crucial question is how: internally without exiting the euro or externally after exiting the euro...

The answer is not clear. Internal devaluation through inflation in the core may not be available because of resistance in the core and because of the ECB's goal of maintaining price stability through deflation in the periphery. External devaluation, on the other hand, may entail high contagion costs, and also requires the redenomination of assets, liabilities and contracts prior to exit, which is likely to cause severe disruption in the short run. Given that, for the time being, policymakers have excluded the exit option, the emphasis of economic policy must be on seeking possibilities for internal devaluations despite its difficulties.

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