Home > The Economics Profession > Internal versus external devaluation: two examples.

Internal versus external devaluation: two examples.

from Merijn Knibbe

Nowadays, progressive economists want economies to be flexible, while conservative economies plead for rigidity. When it comes to exchange rates. When it comes to labor markets, the positions are, often, radically different. But the progressive economists are right. Wages are sticky by nature – and they already were that way back in the eighteenth and nineteenth century. It’s not a modern phenomenon. They don’t go down easily. Flexible exchange rates are a much better, faster and more effective way to decrease labor costs and enhance the internal and external competitive position of an economy than Danish ‘flexicurity’, Baltic ‘internal devaluation’ or other ways to increase unemployment and therewith decrease labor costs. And they also enable a country to weather grave economic disturbances…

The countries to compare are Denmark (Euro peg) and Sweden (floating exchange rate) on one hand and the Baltic countries Latvia, Lithuania and Estonia (euro peg) and Poland (floating exchange rate) on the other hand. Starting in October 2008, the Polish Zloty and the Swedish Krona started to depreciate, which led to much lower labor costs – and a much smaller economic downturn than in countries which rigidly adhered to a pegged exchange rate.

Technical note: the graph does not show contractual wages but wages actually paid (total wages in the private economy/total hours), all data: Eurostat, Baltics: arithmetical average; Sweden and Denmark: wages divided by six.

In both cases depreciation not only led to a stronger competitive position on the domestic as well as the international market but it also enabled a looser monetary policy, which also boosted the economy. And remember: Danish ‘flexicurity’ and Baltic ‘internal devaluation’ are showcases of conservative flexibility!It seems that external devaluation did enable Sweden and Poland to manage the shock of 2008, while internal devaluation, flexible labor markets, easy firing and high unemployment did not save Denmark and the Baltics. As a result, employment and unemployment developed much better in Poland and Sweden, while wages (in euro) are already more or less back to their initial level…

  1. June 25, 2011 at 2:14 pm

    Given that wages are sticky downside, a question then is, why would wages need to fall? If the demand for a particular product falls, labor could shift to another product. Thus what is needed is not so much flexibility in wages but in switching industries or employers. Here Europe makes labor laterally sticky by restricting employee turnover.

    If macro demand falls, one would then ask: why? The ideal is to prevent the downturn rather than force down real wages.

    • Merijn Knibbe
      June 25, 2011 at 9:21 pm

      A note on the lateral mobility of labor:

      one of the best things of the EU is that international freedom om movement of labor has increased very much – and is still increasing. And people take this opportunity: at this moment there are supposed to be about 700.000 Polish in the UK. It works!

    • merijnknibbe
      June 27, 2011 at 1:27 pm

      A note on macro demand:

      I think that Austrian and Post-Keynesian economists should acknowledge that they have a lot in common when it comes to their views of the role of excessive and reckless lending and the financial system as a cause for devastating asset/collateral bubbles.

  2. ahmed desai
    June 25, 2011 at 8:45 pm

    Silly contrast.

    Implicit assumption is that relative wages are key determinant of competitiveness, which in turn is key determinant of growth. Neither is true.

    On competitiveness relative productivity is key. Relative productivity is a function of investment.

    In 2009, Denmark contraction was -5.2% of GDP, Sweden was -5.3% (Eurostat). Investment was -4% and +6.3% respectively.

    Sweden and Poland (via EU funds) increased public investment. Which is why former rebounded sharply and latter escaped recession altogether.

    • Merijn Knibbe
      June 25, 2011 at 9:06 pm

      When I have to divide Danish and Swedish wages by six to get them into one graph with the Polish and Swedish ones, it is clear that there is more to competitiveness, in the longer run, than just absolute or relative wages. The high wages in Sweden and Denmark can only be explained by past productivity enhancing investments (not just in fysical capital, of course), which over the course of decades led to high relative productivity .

      And the graphs indeed only show one aspect of a complex situation – letting their currencies depreciate also allowed these countries to lower interest rates (in contrast with the Baltic countries!) while, indeed, public investment is important too (though it often takes some time before investments lead to higher productivity).

      But it’s not just about public investment – it’s about total demand. An increase in public investment can, sometimes, surely compensate lower domestic or foreign demand. But it really helps when such policies are aided by a lower currency.

  3. Garrett Connelly
    June 26, 2011 at 12:04 pm

    I earned $1/hr as a young teen doing odd jobs after school in the 1950’s, that is equivalent to $16 per hour today, in the US. I mentioned this to a young butcher who is married with two children, he said that is about what he earns per hour today. My point? The labor market is a figment of economist’s imaginations; a market implies freedom of information flow and at least a modicum of social justice, ethics and equity. This mysterious wage stickiness concept is a result directly attributable to government actions supporting corporatist ideology and short term profits.

    We all know that the US helped overthrow the democratically elected president of Honduras. What was his main transgression? A plan to raise the minimum wage brought President Zelaya the same middle of the night kidnapping as Bertand Aristide, who planned the same policy in Haiti. And the United States is not alone in this policy of suppressing wages in Haiti, it is currently joined by the European Union and United Nations to disenfranchise voters by not allowing the peoples favorite political party, Lavalas, to run a candidate in the most recent presidential election.

    The more insidious nature of economist complicity in the falsity of labor market existence is easily seen in the Harvard Economics Department; there, bright young African students are taught that corporate agriculture is more efficient than indigenous agroecological family farms. The actual truth being it is more efficient per hour of semi-slave migrant labor per hour but less efficient per hectare of land cultivated agroecologically by free and independent citizens. Why is Harvard University teaching this falshood? When the young African Phd returns to advise his or her government to corporatize agriculture, policies are developed that family farmers off the land to make room for corporate factory farms, and the Harvard endowment is involved in the land grab which converts free african citizen farmers into wage labor market slaves living in ghettos and farm camps.

    A more complete analysis exploring the evolution from slave labor through guilds and serfdom to wage labor can be found in “Economics Unmasked” by Philip Smith and Manfred Max-Neef. One of their points; people living in the age of serfdom could not look ahead to see the age of wage slavery any more than we today can look ahead and see the next cultural step. An undetermined next step in cultural evolution will be taken with regard to distribution between labor and capital. Will it hasten ecological collapse or accompany peace, justice and equity?

  4. Norwegian Guy
    June 27, 2011 at 1:16 am

    It is interesting that Denmark and Sweden have adopted so different monetary policies. Both counties rejected joining the eurozone after referendums in 2000 and 2003, respectively, and they are both ruled by relatively EU-friendly right-wing coalition governments. They have much in common economically, geographically, politically, and culturally. Still, one of them has chosen to peg their currency to the Euro, the other has not. Are there any explanations for why Denmark has chosen the wrong policy, while Sweden has not made this mistake?

    Similarly, it is quite strange as well, that the Baltic states and Poland have chosen different policies. If anything, I would perhaps expect Poland, which borders a couple of eurozone countries, to be more interested in adopting the Euro, than countries, which don’t, like Lithuania. Or is it the other way around, that Poland doesn’t want to have the same currency as Germany, while the Baltic states don’t have a problem with that?

  5. merijnknibbe
    June 27, 2011 at 11:48 am

    The latest news on Denmark: a major Danish bank failed.


    And the regular reader of this blog, which has included Denmark with the GIPSD countries for quite some time, will disagree with the next phrase of this article:

    “Crisis and rogue waves never come from the direction and area you expect. They always comes from the fringe catching everyone off guard. While the equity and bond markets have been focused on problems with the PIIGS, Amagerbanken, a Danish bank, failed yesterday”

  6. merijnknibbe
    September 12, 2011 at 12:10 pm

    The graph’s have gone! I’ll try to fix this.

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