Sudden Stops

Krugman on Iceland

Part of the story, of course, is that Iceland refused to take responsibility for the debts run up by runaway bankers. But the other part of the story, surely, involves the exchange rate. The others were either on the euro or insisted on remaining pegged to it; Iceland allowed a big depreciation of the krona.

Basically, what all of these countries experienced was a “sudden stop” — huge inflows of capital came to a screeching halt. What has to happen if a country is going to adjust to such a sudden stop is a sharp fall in the relative price of its goods and labor, because it needs to export much more and/or import much less. If you’re not going to get this via a currency depreciation, you have to have an “internal devaluation” — a fall in money wages and prices.

And nominal wages are downwardly rigid. That’s simply a fact, true always and everywhere.