Devaluation Is Austerity Done Right

A harbor employee covers fish with ice before storing in Reykjavik on Oct. 9, 2008

Photo by Olivier Morin/AFP/GettyImages.

I’m much more bullish than Kevin Drum is on the idea that Iceland’s approach to the 2008 financial panic, like Argentina’s approach a decade ago, is a model for the rest of the world. Default and devaluation has a lot of merit. But I heartily endorse this point:

Also worth noting: the Icelandic krona got devalued a lot. In 2008 a euro bought 90 krona. Today it buys 160 krona. That means imports are a lot more expensive than they used to be. And state spending, although it went up in krona terms, was cut sharply in real terms. Iceland isn’t really an anti-austerity poster child.

Currency devaluation is best understood not as an alternative to austerity, but as the correct way for a debt-burdened society to implement austerity. To deleverage, society-wide consumption needs to drop relative to income. Currency devaluation makes that happen. Trying to effectuate the consumption drop purely through tax hikes and budget cuts has two big problems. One is that it reduces incomes along with consumption which makes the necessary amount of consumption-cutting even deeper.

The second is simply that it’s really tough to implement.

If your pension gets cut, you can’t just call AT&T and say “Hey, my pension got cut so I think I should get a proportionate break on my cell phone bill.” Not only does the average person wind up suffering, but there’s enormous variance in the suffering. If you devalue your currency, by contrast, all domestic stuff gets downward priced automatically. Then things that are too scarce at the new lower prices adjust back upward. On paper, there’s a symmetry here but in the real world it looks very different.