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It shouldn’t take a Greek tragedy to remind us that austerity doesn’t work. It maximizes the pain of necessary adjustment.

As with an external deficit, adjustment to a related internal deficit is ultimately the same under any exchange rate regime. Domestic production must rise relative to domestic absorption of goods and services, or absorption must fall relative to domestic production. Real incomes must decline. The terms of trade must worsen.

Milton Friedman and others reminded us decades ago that such internal adjustments necessary to reverse an external deficit were ultimately the same under a gold standard, flexible exchange rates, or some hybrid exchange rate regime. These necessary adjustments are triggered by a variety of price and income signals. However some of these triggers are more painful than others.

The fundamental difference is that under a fixed exchange rate real income declines must come through nominal income declines. Peoples wages and incomes have to fall in nominal as well as real terms. The problem is that nominal incomes and prices are sticky in a downward direction. It makes people cranky, as we see.

A depreciation of a flexible exchange rate can trigger the same necessary real adjustments, but with less pain since the exchange rate itself will alter the relationship of internal prices to external prices without the adverse fallout of nominal price and income deflation. The adjustment will still leave people poorer. It will reduce domestic absorption of goods and services without the unemployment that results from sticky nominal wages. The pain will be spread more evenly among the consuming population and not be born primarily by those who lose their jobs.

Another way of putting it is that a flexible exchange rate makes sticky internal prices and wages flexible to the rest of the world. There is still pain in adjustment, but it comes through lower real wages and incomes rather than total loss of wages and incomes by part of the population–not necessarily the part that caused the problem or benefited unduly under the old regime.

The ongoing fiscal discipline needed for a common currency to work in Europe was appreciated, but probably not sufficiently. The three percent budget deficit rule for admission was the right way to go. Who would have thought that Greece’s three percent would turn out to be thirteen? Who can imagine that the draconian measures now taken will lead to a good outcome?

Source: Austerity Doesn't Work