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.