As a macro framework for analysis, consider the travails of the euro-area in terms of the macroeconomic policy trilemma (1/). Here is the framework:
i. Balance of payments trouble when external credit dries up (sudden stop) ==> solvency threat via banking system and sovereign debt via lender-of-last-resort / contingent debt.
ii. Maintenance of the existing monetary order (the system of irrevocably fixed exchange rates) is conflated with the preservation of society itself (e.g. Angela Merkel in May 2010 conflated euro-zone integrity with the existential status of the EU.)
iii. In fealty to (ii.), pursue austerity. In trilemma terms: adjustment is attempted on the backs of taxpayers/ workers.
iv. Monetary non-neutrality (2/) makes deflation a highly unlikely solution both to debt and competitiveness problems.
v. Repeat (iii.) until …
vi. Political upheaval or solvency crisis (the official lending stops and the sovereign cannot raise funds on the capital markets).
vii. Adjustment comes in one or a combination of the following:
a) Devaluation (for competitiveness, to achieve external surplus) and default (partial or total; also to achieve external surplus).
b) Capital controls (first on current account, then covering all transactions). Note that capital controls can be instituted precisely in order to repay external creditors; it is a way of marshalling all available foreign exchange for that purpose.
c) Trade barriers
Note that c) is really just a version of a) for those unwilling for several reasons to part with the irrevocably fixed currency regime. Does this suggest that if euro-area is unable to countenance disintegration (new currencies), then trade barriers and/or capital controls are next? Maybe not as crazy as it sounds.
1/ The trilemma is the recognition that policymakers cannot simultaneously enjoy all three of the following: fixed exchange rate; policy independence; and currency convertibility.
2/ In order for deflation not to be injurious, money must be ‘neutral’ — in other words, real effects must be indifferent to price increases and declines. The reality is that, with a few notable exceptions (Hong Kong), money is almost never neutral. For example, deflation might well contribute to insolvency through heightening the real debt burden and unemployment by raising the real wage. Workers DO accept eye-watering wage cuts but never on the order required to achieve competitiveness for the economy. Remember, in a balance-of-payments crisis, the economy needs to shift into a surplus, not just a balance. The implied adjustment in the real exchange rate is sizeable. Unless you believe in the “immaculate transfer”.