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March 25, 2012, Sunday

Fiscal devaluation instead of an exit from euro

I believe the current stabilization programs aiming to cope with the debt crisis are in a deadlock. This is particularly true in the cases of Greece and Portugal. This is also likely to be true in the near future for Spain and Italy if the ongoing structural reform programs -- basically in labor markets -- do not work.

There are two major problems. First, wage deflation and austerity measures are undermining growth. It is well known that without growth stabilization, programs will fail to control mountains of public debt and additional debt restructuring will be needed. I discussed this issue in my recent March 5 column, “Sisyphus and the Danaids.” A second problem must also be taken into consideration: workers' resistance to wage deflation and austerity measures. Greece will hold general elections in April that could end with the victory of parties that oppose the stabilization program. And Portugal seems to be following in the steps of Greece regarding political economy issues. The current stabilization programs, therefore, can be thrown into the trash without waiting to see whether or not they work.

A possible alternative to this flawed strategy is an exit from the euro. Heavily indebted southern European countries have outright rejected this option, for obvious reasons. German Chancellor Angela Merkel has also resisted this option. She is afraid of a probable breakup of the eurozone if some members leave it. Many influential American economists and I do not share this fear but what matters, of course, is the conviction of the chancellor. Is there a third option? Apparently yes. In a recent Dec. 6, 2011 paper, “Fiscal Devaluations,” Emmanuel Farhi, Gita Gopinath and Oleg Itskhoki from Harvard and Princeton showed that a tax restructuring called “fiscal devaluation” can mimic the desired effects of an exchange rate devaluation, which would be the outcome of an exit from the euro.

The authors summarized their ideas and findings on March 16 in a version for non-economists called “A devaluation option for Southern Europe,” published by the Project Syndicate. Fiscal devaluation as an alternative to exchange rate devaluation is an old debate in economic literature, going back to the days of the Gold Exchange Standard monetary system, when exchange rate devaluations were not allowed in principle. Two options were considered back then. The first option called for increasing import tariffs and subsidizing exports. In the second option, value added taxes (VATs) could be increased to push exports and discourage imports while decreasing payroll taxes to lower labor costs and improve competitiveness. The first option is obviously out of the question in a fully integrated free trade market such as the EU market.

An enormous gap in competitiveness has emerged between southern and northern Europe. According to Farhi, Gopinath and Itskhoki, “From 1996 to 2010, unit labor costs in Germany increased by just 8 percent … Compare that to 24 percent in Portugal, 35 percent in Spain, 37 percent in Italy, and a whopping 59 percent in Greece.” This gap has to be restored if growth is to be sustainable. The theoretical model and simulations in the aforementioned paper prove that fiscal devaluation can correct this international gap in unit labor costs as much as exchange rate devaluation, but complementary measures must be provided. The two most important of these are a decreased consumer tax and an increased income tax. Increasing taxes is particularly required to maintain a balanced budget. Of course fiscal devaluation is not a panacea for southern Europe, and its defenders point out that debt structuring, liquidity support from the European Central Bank and structural reforms would still be needed.

Could the fiscal devaluation option work? Maybe, but I have some doubts. I see at least three critical points:

1- Let me start with the case of Greece. The competitiveness gap is so high that fiscal devaluation can hardly fulfill it. Indeed, the required VAT increase and payroll tax decrease would be so high that they would likely be unrealistic to implement. Moreover, the necessity of raising income tax would also be problematic, given the administrative inability of Greece to collect this kind of tax. Of course, a similar problem does exist for the others, but to a lesser degree. So the practicality of the required tax increases and decreases has to be investigated.

2- How would the switch from the current strategy to the alternative one be implemented? Should one wait until the current strategy fails? Would it not be too late?

3- If fiscal devaluation in the EU is accepted as the tool to control the loss of competitiveness, would not a new kind of “beggar-thy-neighbor” system be permanently installed, ending the hope for fiscal integration?

Many questions and few answers for the moment.

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