A more recent example of devaluation being a part of the exit from economic crisis is Iceland. Her currency lost more than half its value during 2008 amid a collapse in the banking system. In the most recent OECD report on the country, GDP is projected to grow by 2.2% this year and 2.9% in 2012 with the inflation shock coming from the devaluation having run its course.
Iceland growth
While there is still a lot of uncertainty about the outlook for the Icelandic economy it is slowly getting back on track with unemployment falling and private consumption picking up. Iceland is even forecast to have a much lower government budget deficit than most EU member nations. Interest rates, at just over 4%, are higher than in most other OECD countries but have fallen from 18% at the time of the devaluation.
Of course, currency devaluation is not an option for eurozone members. The economic adjustment has to be taken through reduced domestic inflation associated with a drop in output – in other words, a severe recession in order to restore competitiveness.
This is exacerbated by the tightening of fiscal policy. It is not a very palatable mixture of policy. The likes of Greece, Portugal and Ireland, with Spain and Italy to a lesser extent, have to suffer the pain of economic contraction and, in order for the euro to survive other nations have no choice but to provide large scale financial assistance.
Despite a better tone in the markets this week I am not sure that investors are genuinely feeling that we are closer to a more credible solution for the European crisis. Thoughtful investors came to the conclusion long ago that significant debt relief is needed in Greece and probably in Ireland and Portugal, while there are still risks related to Spain (because of the housing market and the banking sector) and Italy (because of the political difficulties of implementing further fiscal reforms).
Too much politics
Yet few are convinced that the appropriate architecture is in place to meet these challenges. To keep the break-up of the euro a very distant possibility, we have to see policy makers manage an orderly restructuring of Greek debt and establish a strong mechanism to make sure that debt adjustment takes place in other countries in a meaningful and transparent way.
The uncertainty is political – in what way can Europe as a whole establish these arrangements when they will probably bring some loss of fiscal sovereignty. If this is unacceptable in some quarters then the options are a fracturing of the zone or persistent moral hazard, which I doubt can go on for ever. If a new co-operative arrangement is going to be seen then it has to take the form of more unified decision making and policy implementation and a common funding vehicle. To get there requires a massive leap of political faith.
The base case has to be that these uncertainties will rumble on for a long time, but we will get a more flexible EFSF and we will see some moves towards containing any resolution of the Greek situation. The fire fighting central banks are doing a reasonable job – the ECB is capping Spanish and Italian yields and it was joined by the Fed, the Bank of England, the Swiss National Bank and the Bank of Japan in providing dollar credit lines to cover funding for the global banking system in the run in to year-end. So it may be that the worst tensions can be contained but we may not necessarily see a massive improvement in sentiment.
