Playing with Fire: Internal Devaluation for the GIPSI Countries

European authorities are encouraging internal devaluation by GIPSI countries in order to improve their competitiveness and reduce current account deficits. However, this option introduces an additional source of risk, as it may generate deflation, making fiscal consolidation for these countries even harder to achieve. Several authors have suggested that an enhanced coordination of national fiscal policies would be preferable. This paper contributes to the debate in two instances. First, we analyze the main drivers of debt dynamics for peripheral versus core countries in the Eurozone in the last decade, to evidence that GIPSI countries should focus on a fiscal consolidation that does not damage growth, while deflation should be avoided. Second, we implement a scenario analysis to analyze the effectiveness of a coordinated policy among Eurozone members, where core countries accept a 3% target for inflation and reduce the pace of their fiscal consolidation, while GIPSI countries focus on fiscal consolidation with a low (but positive) level of inflation. This coordinated policy might be a better option as it (i) increases the competitiveness of GIPSI countries while avoiding the risks of deflation, (ii) ensures stability of debt for both groups of countries without imposing an excessive inflation target from EU core countries, and (iii) introduces the possibility of a fiscal stimulus. 1. Introduction The sovereign debt crisis in the Eurozone is perhaps the main source of concern on the road to secure global economic recovery and restoring financial stability [1]. The global economic crisis resulted in a large deterioration of fiscal accounts in most advanced economies, being particularly significant for the peripheral countries in the Eurozone (namely, Greece, Ireland, Portugal, Spain, and Italy, a.k.a. GIPSI countries). Fiscal imbalances and debt levels were then aggravated by the expansionary policies implemented at the first stage of the crisis to provide support for aggregate demand and to aid the financial sector. Several authors (e.g., Abbas et al. [2]) warned at that time on the necessity of correcting fiscal imbalances and reducing public debt, and this has been a priority for European authorities since the outburst of the euro crisis. However, austerity policies are leading GIPSI countries to a deep recession, when not to a depression. The debate about fiscal austerity versus economic growth is bitter now, with no consensus about which policy would be better to achieve a fiscal balance while not jeopardizing economic growth. For instance, the