Nouriel Roubini has recently restated the case (see excerpt below), in an untraceable paper that Paul Krugman (NT Times blog) has injected into the blogosphere, that this policy usually fails (viz. Argentina and now Latvia). External devaluation is the much more effective alternative - it lowers your export costs on world markets without inducing a meltdown in domestic demand. Unfortunately, this option is denied to the Europeriphery countries as long as they remain within the Eurozone. In this respect having the Euro as your currency is a lot like being an emerging market economy with external debt denominated in hard currencies you don't control. (Once again Paul de Grauwe has an excellent paper on this point.)
Why would international organizations prefer "internal devaluation" to "external devaluation"? To protect international creditors against an accompanying default? In an interview he gave in the Austrian "Der Standard" after resigning as chief economist for the ECB, Jürgen Stark argued that Greece should be subjected to the same demanding but "successful" policies that had worked so well in Latvia. Evidently Nouriel Roubini and Jürgen Stark have been living on very different economic planets these last few years.
In the Eurozone case, the alternative would have been to have the creditor Eurocore countries (i.e., mostly Germany) inflate while the peripheral countries freeze their wages and prices, accompanied by an overall Euro devaluation. A path not taken...
The experiment with "internal devaluation" will not be decided in ivory towers but rather on the ground. The current political turmoil in Greece and the zombie Burlesqueconi government in Italy are just a taste of things to come.
Roubini on "internal devaluation":
The international experience of “internal devaluations” is mostly one of failure. Argentina tried the deflation route to a real depreciation and, after three years of an ever-deepening recession/depression, it defaulted and exited its currency board peg. The case of Latvia’s “successful” internal devaluation is not a model for the EZ periphery: Output fell by 20% and unemployment surged to 20%; the public debt was—unlike in the EZ periphery—negligible as a percentage of GDP and thus a small amount of official finance—a few billion euros—was enough to backstop the country without the massive balance-sheet effects of deflation; and the willingness of the policy makers to sweat blood and tears to avoid falling into the arms of the “Russian bear” was, for a while, unlimited (as opposed to the EZ periphery’s unwillingness to give up altogether its fiscal independence to Germany); and even after devaluation and default was avoided, the current backlash against such draconian adjustment is now very serious and risks undermining such efforts (while, equivalently, the social and political backlash against recessionary austerity is coming to a boil in the EZ periphery).