Devaluation or Deflation?

Italy is in recession. There is nothing extraordinary about this, as Donald Rumsfeld notoriously said 'stuff happens', and economies do have their ups and downs. But this recession is a little different, since it is structural and not cyclical. For the Italian economy to return to a better trajectory something has to be done, but what? Morgan Stanley's Vicenzo Guzzo offers two alternatives: devaluation, or deflation (actually the way he puts the alternatives it sounds to me more like a case of: "with which instrument would you prefer I cut your throat sir, the stanley knife or the chain saw"?).

"If Italy intended to restore the pre-1999 competitiveness level, it would have to experience a 25% currency depreciation. While the euro is now down over 5% from the start of the year, such a large correction appears unlikely at this stage. In addition, the economy has steadily lost ground also vis-?-vis its euro area trading partners, as the breakdown of the trade data suggests. Euro depreciation would provide no oxygen on that front. In order to return to pre-1999 competitiveness levels, Italy would have to abandon the current exchange arrangements. To put it bluntly, it would have to drop out of EMU. A 25% devaluation is equivalent to what the economy experienced between 1991 and 1995. Exports scored double-digit gains in the aftermath of the realignment, but domestic demand fell heavily and debt services costs hit 12.5% of GDP. In a replay of those years, Italy would either default on its debt or run toxically tight fiscal policy. This is simply not an option, in my view."

So Italy is caught. To devalue it would have to leave EMU. But then even if it could and did, it would go bust. So, on Guzzo's reading, the only remedy left is substantial deflation, that is an ongoing reduction of wages and prices which would enable competitiveness to be restored. This sounds very much like the 1930's and an Italy stuck with a modern version of the gold standard. It also sounds like going through a recession which could turning out lasting for a number of years, even if this was politically feasible it would be extraordinarily painful for many of those most immediately affected.

This, of course, is a question which is widely treated in the textbooks. So would anyone like to suggest a rival 'escape strategy'?