A Devaluation Option for Southern Europe

Vicious circles of economic instability, devaluation, and capital flight have brought down seemingly unbreakable regimes throughout history. This probably explains the whiff of panic that followed China s tiny, but totally unexpected, devaluation of the renminbi.

The standard way to buffer the effects of austerity is to marry domestic cuts to devaluation of the currency. Devaluation renders exports more competitive, thus substituting external demand for the domestic demand that is being compressed.

This reflected a decrease in real terms, due to inflation and the devaluation of the dollar.

This sharp devaluation increased further the cost of debt servicing and the debt to GDP ratio.

If internal devaluation were the solution, the gold standard would not have been a problem in the Great Depression. Internal devaluation, combined with austerity and the single market principle (which facilitates capital flight and the hemorrhaging of banking systems) is a toxic combination.

Manifestations of discrimination include high instances of child and bonded labour, unequal pay, unemployment and emotional devaluation.

A slight devaluation would solve any remaining problem with export demand. This could be an explicit devaluation or an implicit one due to a price reduction, made possible by the reduction in unit production costs resulting from the extra working time at constant pay.

Given these factors, it seems likely that the recent devaluation was driven by a different goal. And, in fact, an announcement made on the same day as the devaluation one that has been largely overshadowed by the panic offers an important indication of what that goal was.

But, since none of these countries has a national currency to devalue, they must substitute internal devaluation for external devaluation. They have to cut wages, pensions, and other costs in order to achieve the same gain in competitiveness needed to substitute external demand for internal demand.

The logic is that a country like Greece needs devaluation to enhance its competitiveness, but that leaving the euro would pose major problems. The alternative would be to cut nominal wages ( internal devaluation), which is hard to do (though it has been achieved in Latvia and Ireland).

Of course, regaining the exchange rate as an instrument for competitive devaluation could help overcome competitiveness losses due to soaring unit labor costs. As Argentina showed after its default and devaluation in the winter of 2001 2002, such a move can reignite exports and economic growth.

First, devaluation would distribute the costs of rebalancing more evenly, making it easier to clear the burden sharing hurdle to deeper reforms. Second, floating exchange rates imply that devaluation is an automatic adjustment mechanism, so it occurs without the appearance of an explicit burden sharing choice and the accompanying potential for political gridlock.

The prevailing strategy in Europe remains simply to force internal devaluation on the southern countries, with excessive austerity aimed at causing severe wage and price deflation. While some internal devaluation is being achieved, it is producing so much economic and social dislocation and, increasingly, political upheaval that there is no supply response, despite the accompanying structural reforms.

Thanks to U.S. stock market gains and yen devaluation overnight, Tokyo stocks opened higher on August 12, and Nikkei 225 Stock Average rose 1.10 .

These are reasonable objections, but they should not be allowed to lead to unreasonable conclusions. The alternatives on offer are internal and external devaluation.

Export led growth did not take place rapidly after devaluation, because of either the narrow base of exports or adverse conditions in global markets.

Economically, the BRICS are facing serious challenges. In addition to a well documented growth slowdown, China has lately experienced considerable stock market turmoil and currency devaluation.

So, if internal devaluation is to work, the value of debts, where they already represent a heavy burden, must be reduced. Government debt must be restructured.

But time is working against them two speed Europe is driving member countries further apart. Greece is heading towards disorderly default and or devaluation with incalculable consequences.

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.

Devaluation and debt restructuring worked. In subsequent years, until the global financial crisis erupted in 2008, Argentina s annual GDP growth was 8 or higher, one of the fastest rates in the world.

In a monetary union, there are only two ways to close a competitiveness gap between countries transfers from the more competitive to the less competitive, or internal devaluation, which means real wage cuts.

This leads directly to the third unsolved problem What happens if a country is unwilling or unable to keep within agreed conditions? Inability to issue eurobonds could result in a disorderly default or devaluation.

The second possibility is a more pronounced devaluation of the dollar, bringing it well beyond the current levels relative to both the euro and the yen. Revaluation of the Chinese yuan would also help.

But that announcement came as a surprise (as did the devaluation of China s renminbi this past summer). Capital that had flooded into emerging markets seeking yields no longer available in developed economies abruptly reversed course.

But are European countries with lagging productivity willing to accept depopulation? Alternatively, are they willing to face the pain of internal devaluation, a process that failed under the gold standard and is failing under the euro?

This was no earth shattering event, but financial markets responded as if a meteorite had struck them. The negative reaction is no mystery China s devaluation was a textbook example of how not to conduct exchange rate policy.

Only the IMF could have offered the third option of an orderly exit. Greece should have been told that it could reap the benefits of devaluation, while the international community would act to minimize the attendant costs.

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.

The monetary easing undertaken by the US Federal Reserve raised expectations for a devaluation of the US dollar that might help US exports. But domestic savings remain low in the face of persistently high levels of public debt.

The recent Greek elections have brought more radical parties to the fore. Alexis Tsipras, the head of the Coalition of the Radical Left has a valid point internal devaluation cutting wages and prices is failing as a strategy.

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.

The systematic reforms in the United Kingdom, Denmark, Sweden, Poland, and Estonia have much in common. First, all were caused by a profound crisis of the social welfare state falling output, rising unemployment, large budget deficits, inflation, and devaluation.

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.

It is reported that, despite the international economic downturn, the devaluation of the Russian ruble and overseas remittance reduction and a series of other adverse external factors, 6 growth was still achieved in the economy development of Tajikistan in 2015.

Devaluation is the tried and true remedy for such ills. But a 2 change in currency values is too little to make much of a difference, given that wages in Chinese manufacturing are rising at an annual rate of 10 .

A single large devaluation that gets the entire adjustment out of the way minimizes this risk. Indeed, if investors expect the sharp improvement in competitiveness to lead to stronger economic performance, the currency will recover some of its lost value.

The first, following the collapse of the USSR, was almost cataclysmic nothing in the shops, the country in bankruptcy, all savings lost. The other affected everyone but was less severe Russia s 1998 default, which saw a fourfold devaluation of the ruble.

If you find a correlation between deficit reduction and growth, the reduction could be causing the growth or vice versa. (Or both the deficit reduction and the growth could be due to something else devaluation or higher exports, for example.)

It could be that Chinese policymakers regard the 2 devaluation as a down payment the first in a succession of downward adjustments. But, in that case, they violated the first rule of exchange rate management Don t cut off a cat s tail in slices.

Since the 2000 s, China s gross assets and gross liabilities have increased dramatically, owing to the success of China s trade promotion and FDI policies. As a result, China s net international investment position has become very vulnerable to the devaluation of the dollar.

In deep financial crisis, traditionally social democratic Denmark elected a conservative prime minister, Poul Schlüter, a jovial man with a bow tie. One of his first decisions was to peg the Danish krone to the Deutschmark to stop the inflation devaluation cycle.

The irony is that the euro has been a hugely successful project, bringing considerable stability to participating countries. Indeed, without the single currency, many of these countries would have succumbed to a downward spiral of devaluation, default, and recourse to the IMF.

It is widely felt that normal market risks, including currency devaluation risk, should be borne by the private sector and that only those factors out of their control, such as regulatory risks and force majeur, should be covered by the public sector.17