Europe: The Failure of Internal Devaluation

Quite apart from the resolution of debt and banking/credit problems, differences in competitiveness, and external account imbalances, are central considerations impacting on the success or failure of the European experiment with a common currency.  This short article looks beyond simple cross-country  comparisons of unit labour cost trends and evaluates the role that austerity policies have played in relation to the failure of internal devaluation.  An alternative policy approach is proposed for discussion.

Many European countries are now facing multiple complications: deflationary tendencies are strengthening, public debt burdens and unemployment continue to rise, and the internal devaluation process is failing.

In his recent VoxEU article ‘What’s wrong with Europe’, November 5, Paolo Manasse notes that in some peripheral economies price and wage rigidities have amplified the recessionary impact of demand shocks.  In his VoxEU article ‘Austerity and stupidity’, November 6; Lorenzo Bini Smaghi demonstrates, inter alia, that countries that are at the lowest end of the competitiveness ranking are also those that have grown less after the crisis, a not unsurprising result.

This article expands on the competitiveness theme as, with a common currency in many countries, continuing differences in competitiveness must be a central consideration in the unfolding European tragedy.

Price level adjustments are needed to establish support for the traded-goods sectors of deficit countries within the Eurozone, given that the single currency precludes the use of exchange rate adjustments to correct underlying external account imbalances.  The practical problem, however, is that the internal devaluation process driven by austerity has been patchy, slow, sclerotic and completely inadequate.

Wage and price adjustments through austerity

The architects of austerity policies believe that austerity can bring about needed reductions in wages and prices. According to the theory, austerity reduces aggregate demand and pushes up unemployment.  In turn, the higher unemployment is expected to moderate wage claims, and lead to the required reductions in nominal wages.  Prices are then expected to fall down in line with wages.  The intended result is that national price levels decline in trade deficit countries (relative to those in surplus countries), and competitiveness in the deficit countries is improved.

Unfortunately, the facts do not support the theory.

Since 2009, unit labour costs have fallen back to their 1999 levels in Ireland, Portugal and Spain; but unit labour costs have continued to rise in France and Italy.  However, as unit labour costs in Germany are now 10 per cent lower than in 1999, the required adjustments are very far from complete. (Source: OECD, ‘Early Estimates of Quarterly Unit Labour Costs’, June 2013).

At the same time, based on IMF forecasts, between 2009 and 2014 consumer prices will have risen by around 9.5 % in Germany, but they will have risen by more than that in Spain (11.2 %), Italy (11.1 %), United Kingdom (16.6 %), Estonia (19.1 %), Lithuania (12.4 %) and Cyprus (11.8 %).  Relative price levels are not adjusting as promised.

And, because nominal wages have weakened more than prices, real wages will have fallen between 2009 and 2014 as follows:  in Greece (around 22 %), Spain (7 %), Portugal (6 %), Ireland (4 %) and Italy (2 %). (Source, Ronald Janssen ‘Real Wages in the Eurozone: Not a Double but a Continuing Dip’, 2013).  Between 2008 and 2012, real wages fell by 10 % in the United Kingdom (IMF Article IV Report, United Kingdom, 2013).  Between 2008 and 2011, real wages fell by 2 % in Estonia and by 5 % in Lithuania.

Austerity and internal devaluation are failing because rigidities in labour markets preclude market forces — high unemployment — from driving down nominal wages sufficiently.  As well, there is insufficient competition in product markets in deficit countries, and, consequently, prices of domestically produced goods do not fall, pari passu, in line with nominal wages.  Finally, even though unit labour costs have fallen somewhat in periphery countries, unit labour costs have also fallen in Germany due to wage restraint policies.  The net result is that prices in some of the periphery countries have actually risen faster than prices in Germany since 1999.  The hoped-for adjustment in relative price levels has simply not occurred, despite years of policy application: indeed, the situation has deteriorated.

At the same time, austerity has led to large reductions in real wage incomes.  As a consequence, aggregate demand has been dragged down, compounding the substantial and simultaneous cumulative withdrawal of public demand under fiscal austerity across European countries. (The effects of withdrawing public demand (fiscal consolidations) have been very substantial, and greater than estimated by the IMF: see Jan in ‘t Veld, ‘Fiscal consolidations and spillovers in the Euro area periphery and core’, Economic Papers, 506, October 2013, European Commission).

Wage shares in some European countries were experiencing a long-term decline before the global financial crisis.  Given that history, great caution is now required, as policies that depress wage incomes and demand further — when aggregate demand is demonstrably already seriously depressed, and deflationary tendencies are strengthening — would drag troubled economies into price deflations and deeper output depressions, in-turn pushing-up debt burdens.  Germany is pushing the periphery down.

The inflation rate in Germany fell to an annual rate of 1.2 per cent per annum in October 2013.  This means that for deficit countries to achieve internal devaluations they need to experience even deeper wage cuts and deflation than before.  Thus through German austerity, wage restraint in Germany and an unwillingness to raise domestic inflation, Germany is imposing deeper deflation on deficit countries, and thereby smothering any prospect of an economic revival in the periphery.  For those living in deficit countries this imposition is increasingly intolerable and unacceptable.

The austerity-led internal devaluation strategy has failed.

Wage and price adjustments using a formal prices and wages policy

Policy makers seem to have given insufficient attention to the possibility that temporary formal prices and incomes policies could hasten, and make more efficient, the internal devaluation process.

The magnitude of required adjustments to prices of domestically-produced goods varies by country.  Consequently, formal wage and price policies would need to be tailor-made, depending on the circumstances faced by each country, and taking into account the imperative to establish appropriate real wage levels if they are currently out of kilter.  But, in essence, the plan would involve reducing all wages in a particular trade deficit country, and at the same time reducing all prices of domestically-produced goods and services in that country; in the simplest cases by a similar amount.  In the simplest case real wages would not fall, as they have under austerity.  In relation to trade surplus countries, some upward adjustment of wages, prices and real wages would assist the overall adjustment process.  All of these changes could be coordinated and affected simultaneously, overnight.

The main components of temporary, tailor-made wages and prices policies would be a general wage rule, a general price rule, strong competition policies, and legal authority to police the adjustment and to impose substantial fines where the basic rules are not followed.

A formal wages and prices policy was adopted by the Australian government in 1982 to deal with excessive real wage cost levels, inflation and high unemployment.  The policy was totally successful: real wage costs subsequently fell by 12 per cent, inflation fell back and full employment was restored.  If formal wages and prices policies could rebalance competitiveness among European countries, then troubled countries could benefit from increased external demand and increased export income.

Need to stimulate domestic demand as well

As European counties approach the zero bound with the policy interest rate, and with current austerity fiscal policies contributing substantially to economic contraction and stagnation, new approaches to providing domestic economic stimulus must be developed.

In relation to internal demand, revamped, more effective and closely coordinated monetary and fiscal policies will be needed to raise domestic demand.

Quantitative easing has been suggested as a way forward for Europe. Unfortunately, because quantitative easing impacts asset prices and does not drive consumer prices, there is no compelling evidence that quantitative easing would lift internal demand for ordinary goods and services, or prevent the spread of deflationary tendencies.  Furthermore, if the Eurozone — without a current account deficit imbalance overall — engaged in QE it would effectively be joining the currency war propagated by the United States, Japan and the UK, in respect of which the net benefits for the international economy are zero-sum.  But the wage, price and external account adjustments required within Europe — the subject of this article — would not take place

Economic stimulus must come from budgets putting more money into the economy than they take out.  Overt money financing of budget deficits would allow for greater monetary policy differentiation across European countries. Overt money financing would permit higher budget deficits to stimulate internal demand and economic activity in individual countries without adding to public debt or interest rates.  Contrary to popular perception, overt money financing is not precluded by the Lisbon Treaty (see Biagio Bossone and Richard Wood, ‘Overt Money Financing of Fiscal Deficits: Navigating Article 123 of the Lisbon Treaty’, EconoMonitor, July 22, 2013.)


Based on the above facts and economic logic, it is reasonable to conclude that, with current policies failing to address internal and external balance requirements, the combination of prices and wages policies and overt money financing of budget deficits would provide a policy mix that would greatly improve the economic prospects of troubled European countries.