Internal devaluation does work, it

28th September 2012

He says: "So over time gradual deflation (or deflation relative to trading partners) increases competitiveness, leading to recovery toward full employment; this implies a period of above-normal growth and, implicitly, above normal growth in exports as well. So if you see these things it isn't a refutation of the approach, it's actually what the model predicts.

The point, however, is that it may take a long time – and there's massive pain along the way."

Unfortunately the pain of restructuring is taken predominantly by those who can least afford to do so. Where government cuts and tax hikes have had most impact is on those who were already paying into the system – it's impossible by definition for the government to dictate to the black economy. Yet if you declare your income and pay your tax then the state already knows where to look.

There have, of course, been efforts to rein in the black economy, which some estimate account for as much as 20% of GDP. For example, earlier this year Spain announced plans to crack down on tax evaders including measures designed to "forbid cash payment for more than 2,500 euros ($3,300) and demand taxpayers declare overseas assets". Yet there are already doubts over how successful the measures are proving.

Back in July Shaun Richards, Mindful Money's economics blogger, called for the Spanish government to mobilise the black economy. As he pointed out, however, "tax rises are likely to take [this process] in the opposite direction" as increasing numbers of people look to preserve their wealth. Perhaps this is part of the reason why, despite the tax increases, government spending is up 8.9% while tax receipts have fallen by 4.6%.

The narrative will be painfully familiar to those, like Krugman, who have long argued against the logic of cutting into a downturn. It is not simply a case of Keynesian theory versus monetarists, it is compassion versus ideology.

Roger Bootle, the managing director of Capital Economics, has described the eurozone in its current form as a "depression-making machine". It is hard to find fault with that point. European policymakers have decided to prolong the downturn in the region in order to restore competitive cohesion across the currency bloc. If allowed to continue it could achieve this goal, but with every new round of cuts or national election the risk of a costly collapse of the process grows.

Krugman argues that "if the biggest problem is actually one of maintaining social and political cohesion, which seems to be the case, it's actually counterproductive even for the creditors". These creditors include the German private sector, which could suffer widespread loses in the case of a disorderly break up.

The fact that Germany has already ceded sufficient ground to allow the European Central Bank (ECB) to launch its bond buying programme shows the appeal of self-preservation remains strong. It has not yet, however, been enough to prompt Angela Merkel to be frank with the German electorate about the way forward.

Pro-austerity voices are fond of using the argument that by the time you know when bond markets have had enough, it's already too late. How many of them are looking at the protests on the streets of Athens and Madrid and asking themselves the same question about the tolerance of those suffering under it?


More on Mindful Money:

Popular unrest in Spain could push Europe into a dangerous new phase

Greece is falling further into a debt-filled abyss

FactCheck: Austerity isn't a vote winner

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