Playing with fire: Internal devaluation

The journal ISRN Economics by Hindawi, the largest international Open Access publisher and the first subscription publisher to convert its entire portfolio of journals to Open Access (source), has published this week a paper by me and Fernando Rey about the current Euro crisis: ‘Playing with fire: Internal devaluation for the GIPSI countries’.


You may download the article in .pdf HERE. In what follows we provide only a brief summary of its contents.


Correcting fiscal imbalances and reducing public debt has been a priority since the outburst of the euro crisis. European authorities are fostering internal devaluation of peripheral countries. The idea is simple: when a debt crisis triggered in countries with a currency of their own –like several episodes of emerging countries in the past- a classic solution was that the IMF financed the country and imposed fiscal consolidation and devaluation, combined with an expansionary monetary policy. For Eurozone members this is not possible since the monetary policy has been transferred and the option for national currency devaluation has been switched off. Hence, authorities suggest a ‘second best’ option would be internal devaluation through wage cuts. However, this option introduces an additional source of risk: fiscal consolidation, combined with a credit crisis and with no access to devaluation, generates deflation. Besides, this may be a dangerous strategy in a context where the private sector is heavily indebted and currently ongoing a necessary process of deleveraging.


An alternative policy would be accepting a higher inflation target. Well-known defenders of this option are Rogoff (2011), Krugman (2012) and Stiglitz (2012) –though critics to this idea are also manifold (e.g., Rajan, 2011). In ‘Playing with fire: Internal devaluation for the GIPSI countries’ we suggest an alternative that may satisfy both points of view: how a coordinated policy within the Eurozone, where creditor countries accept an inflation differential above GIPSI countries’ inflation, would avoid the perils of deflation, setting a more suitable scenario for fiscal consolidation of GIPSIs to succeed.





The largest eleven euro members in terms of GDP have been considered for our research, split into two groups: creditor countries on one hand (‘EU core’ countries), which include Austria, Belgium, Finland, France, Germany and Netherlands, and debtor countries (GIPSI countries) on the other, including Greece, Ireland, Italy, Portugal and Spain. We conduct two types of research, an analysis of debt dynamics based on historical data and a forecast for different policy strategies.


I.- Decomposition of debt dynamics

We analyze the main drivers of changes in debt of peripheral versus core countries in the Eurozone, before and after the financial crisis. First, on a country-by-country basis; then, comparing EU Core versus GIPSI countries as a group.
a) Country analysis
We perform a decomposition of debt dynamics from 2004 to 2012 for each country in the sample. For instance, in the case of Spain the analysis shows the effects of the burst of the housing bubble by 2008. The first effects over the debt-to-GDP ratios were driven by the deterioration of public finances due to the drop in public revenues and the sharp increase in the unemployment rate. However, the largest effect over debt levels came with the bank bailout provided by the European authorities later on in 2012. In the pre-crisis years, public finances were healthy and historic budget surpluses (due in part by higher revenues from the housing bubble) were the main driver of a decreasing debt ratio. After the crisis, public deficits were largely the main driver of a deteriorating debt dynamics.


b) EU core versus GIPSI
Then we perform a pairwise comparison of the driving factors between EU core and GIPSI countries. The Figure below evidences a strong correlation between primary balance (PSR) and change in debt. One percentage point of additional fiscal imbalance has explained, on average for the eleven countries, from 2008 to 2012, an increase of 0.93% in the debt ratio every year. Since GIPSI countries have experienced a large deterioration in their fiscal balances that is yet to be solved, a clear result of this analysis is that the main objective of any policy strategy for peripheral countries should be fiscal consolidation.

However, this strategy should not damage growth. The next Figure evidences there is also a positive (though weak, R2 = 0.46) correlation between debt dynamics and growth.
This effect is even more intense: over five years, a percentage point of lower GDP growth caused, on average for the eleven countries, an increase of 1.94% in the debt ratio every year. Put it other words, whenever a fiscal consolidation of one percentage point reduces growth in more than half a point, the net effect would be an increased debt ratio. The classic fiscal consolidation versus growth dilemma, once again.
II.- Scenario analysis

We conduct a scenario analysis for fiscal consolidation by EU core and GIPSI countries. We consider two possible alternatives. First, European countries follow an ‘isolated strategy’ –the alternative European authorities are promoting- where core countries set zero deficit and low inflation as policy targets, whereas GIPSIs implement a strong fiscal consolidation and an internal devaluation that generates deflation. Second, a situation where core and peripheral countries set a ‘coordinated policy’. Such coordinated policy would consist of core countries accepting a slightly higher inflation target, whereas GIPSI countries would focus on gradual consolidations and structural reforms in order to boost productivity and enhance their competitiveness.
Results show how harmful deflation would be. Internal devaluation might only make fiscal consolidation for GIPSI countries even harder to achieve. Instead, setting a coordinated policy among Eurozone members, where EU core countries accept a 3% target for inflation and reduce the pace of their fiscal consolidation, while GIPSI countries focus on fiscal consolidation with a low (but positive) level of inflation. This would on one hand avoid the perils of deflation on GIPSI countries, while on the other it requires an inflation goal to EU core members only one percentage point above the ECB’s target. We show the coordinated policy might be a better option as it (i) increases the competitiveness of GIPSI countries while avoiding the risks of deflation, (ii) ensures stability of debt for both groups without requiring an excessive inflation target from EU core, and (iii) introduces the possibility for a fiscal stimulus that boosts demand in core –and, indirectly, in peripheral- countries.

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