Wages and debt deflation

Alan made a comment in response to John Fitz that I think people need to think carefully about: wage cuts will be deflationary in that they will increase the real burden of debt. The Latvian piece Philip linked to talks about this, and Paul Krugman has been writing about this also.

I suppose that unlike in Latvia and other countries, most Irish household debt is owed to Irish financial institutions. As Krugman says, this implies that if we could adjust the real exchange rate by devaluation, that would be preferable to doing it through domestic deflation. However, devaluation is not an option for us. So, Alan is right: writing down the debt would seem like the best solution, assuming it were possible. Of course, you would like the banks rather than the taxpayer to take the consequent hit, and there is a fat chance of this with our current government.

If debts cannot be written down, then wage cuts will depress the economy still further through this mechanism. As will tax increases, and expenditure cuts, whether people like it or not. And thus the adjustment mechanism for our economy is most likely to be emigration. Which will of course further reduce economic activity, and asset prices, and increase the losses suffered in principle by banks, and in practice, one fears, by taxpayers. (And reduce GDP and the number of taxpayers, thus increasing the tax rates required to service a given level of debt.)

None of this is to disagree with John, but to point out how bad our options are right now.

Speaking personally, I would really appreciate a detailed debate in the next few weeks about two issues. First, what is the optimal timing of a return to 3% deficits? I am completely convinced by the argument that we are once again living in a Keynesian world, which on its own suggests doing this over a number of years, especially since we are starting with a low stock of government debt. (What else is a low stock of government debt for, one might ask.) The key questions then are: how rapidly will the stock of debt escalate to levels that are unacceptable? What are unacceptable levels of debt? How binding are the constraints which we will face due to increasing demands by governments for loans on world markets? How worried should we be about possible linkages between increments to and the stock of public debt, on the one hand, and the credibility of the government’s bank guarantee scheme on the other?

Second, what does the real exchange rate or labour market evidence suggest about the size of wage cuts required to get the real exchange rate back to some sort of sustainable non-bubble level? Can we do better than picking numbers out of the air?