Sunday, August 31, 2014
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A Devaluation Option for Southern Europe

CAMBRIDGE – This year is likely to mark a make-or-break ordeal for the euro. The eurozone’s survival demands a credible solution to its long-running sovereign-debt crisis, which in turn requires addressing the two macroeconomic imbalances – external and fiscal – which are at the heart of that crisis.

The crisis has exposed the deep disparities in competitiveness that have developed within the eurozone. From 1996 to 2010, unit labor costs in Germany increased by just 8%, and by 13% in France. Compare that to 24% in Portugal, 35% in Spain, 37% in Italy, and a whopping 59% in Greece. The result has been large trade imbalances between eurozone countries, a problem compounded by large fiscal deficits and high levels of public debt in southern Europe (and France) – much of it owed to foreign creditors.

Does addressing these imbalances require breaking up the eurozone? Suppose, for example, that Portugal were to leave and re-introduce the escudo. The ensuing exchange-rate devaluation would immediately lower the price of Portugal’s exports, raise its import prices, stimulate the economy, and bring about much-needed growth. But a euro exit would be a messy affair. The resulting turmoil could very well trump any short-term gains in competitiveness from devaluation.

There is a remarkably simple alternative that does not require southern Europe’s troubled economies to abandon the euro and devalue their exchange rates. It involves increasing the value-added tax while cutting payroll taxes. Our recent research demonstrates that such a “fiscal devaluation” has very similar effects on the economy in terms of its impact on GDP, consumption, employment, and inflation.

A currency devaluation works by making imports more costly and exports cheaper. A VAT/payroll-tax swap would do exactly the same thing. An increase in VAT raises the price of imported goods, as foreign firms face a higher tax. To ensure that domestic firms do not have an incentive to raise prices, an increase in VAT needs to be accompanied by a cut in payroll taxes.

Moreover, since exports are exempt from VAT, the price of domestic exports will fall. The desired competitiveness effects of exchange-rate devaluation can thus be had while staying in the euro.

This policy can also help on the fiscal front. As is true of an exchange-rate devaluation, the positive impact on growth of an increase in competitiveness can strengthen the fiscal position by raising tax revenues. Moreover, an important advantage of fiscal devaluations is that they generate additional revenues in proportion to the country’s trade deficit. For countries that are suffering from weak competitiveness and, as a consequence, running trade deficits, this typically means more revenues, especially in the short run.

Like exchange-rate devaluations, fiscal devaluations create winners and losers. Both act as a wealth levy: inflation means that bondholders suffer a real loss in proportion to their wealth and the size of the devaluation. If taxes on capital are not adjusted, holders of domestic stocks suffer a comparable loss.

By contrast, many transfers, such as unemployment benefits, health benefits, and public pensions, are indexed to inflation, and thus maintain their real value. The same is true of minimum wages. These distributive effects play an important role in the politics of exchange-rate devaluations, and most of these effects appear in fiscal devaluations as well.

Fiscal devaluations already have some advocates. Indeed, French President Nicolas Sarkozy’s government just announced one. And concerns that a fiscal devaluation will conflict with euro rules can be met by simply pointing out that Germany’s government carried one out in 2007, though by another name, when it raised VAT from 16% to 19% and cut employers’ contribution to social insurance, from 6.5% to 4.2%.

In short, there are simple fiscal alternatives to exchange-rate devaluation that can address southern Europe’s short-term competitiveness problems. To be sure, feasible fiscal devaluations would be limited in size. But, together with debt restructuring, accommodative monetary policy, liquidity support from the European Central Bank, and much-required structural reforms, they can help to put these troubled economies on a sound footing without a euro breakup or a major austerity-induced recession.

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  1. CommentedWilliam Wallace

    Sounds doable in theory, but it depends on two unlikely factors. First, firms would need to immediately factor the labor savings into pre-tax price reductions, rather than increasing profits or decreasing losses. Secondly, given the unlikelihood of these price reductions, the impact on consumer spending of higher post-tax prices might decrease aggregate demand enough to offset the benefits of the policy.

    I rather think a lot more focus on structural as opposed to cyclical deficits, and wider EU support for the latter while discouraging the former, would do a lot to put things on firmer footing, while sending a coherent message to the bond markets.

  2. CommentedZsolt Hermann

    Zsolt 01:39 02 Mar 12

    We can forgive economists that they view everything through the glasses of financial and economical adjustments, believing they can solve all our problems by pushing here, pulling there and then everything falls into place again.

    The global crisis is much deeper than a simple economic problem, in truth the economy is just a superficial representation of how we humans relate to each other and the real crisis is there, within our attitude, relationship towards each other.

    But even if stay within the realms of economy and finances all the recommended solutions take it for granted that the present costant growth, expansive economical system can carry on, and we just need to find our way back to the higway that leads us to sunset, when more and more experts, studies shows that this approach is unsustainable at our present conditions we evolved into.

    Sooner or later we have to face the signs and the facts that we have to build a completely new human system from the ground up, starting with the most important components: human beings and how they connect to each other, how they view each other and cooperate with each other in the closed, interdependent, integral system of the 21st century.

    Everything else is secondary and depends on the fundamental principle of the human network in between us.

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