As Europe's banking crisis deepens and the US economy stalls, most discussions of how to stabilise national finances assume only two options: “internal devaluation” (shrinking the economy by cutting public spending) and currency devaluation. Both aim to make countries more competitive: the first using unemployment to lower wages and imports, the second lowering export prices.
The Baltic states, in particular, have applied the first option to an extreme degree. Government cuts have shrunk the gross domestic product of Latvia and Lithuania by more than 20 per cent in two years, while wages in Latvia's public sector have fallen by 30 per cent. The hope is that falling wages and prices will see economies “earn their way out of debt”, creating a trade surplus to earn euros that, in turn, can pay the debts that fuelled the post-2002 property bubble.
The second option has been tried less often. Those eastern European countries that have not yet joined the euro know that currency depreciation would delay their planned European Union membership. It would also raise the price of energy and other essential imports, aggravating the economic squeeze and trade deficit. Most leaders therefore find currency devaluation so unthinkable that, at first glance, austerity seems to be the only choice.