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.