The process of adjustment is compulsory for the debtor and voluntary for the creditor. If the creditor does not choose to make, or allow, his share of the adjustment, he suffers no inconvenience.John Maynard Keynes (1941).
With the incoming European elections in May 2014, several political parties propose that southern European countries (France included) leave the monetary union to devalue their national currencies so as to restore their competitiveness. For starters, we can two remarks to be clearer. Firstly, competitiveness in a broad sense includes price competitiveness and non-price competitiveness. The first concept concerns the price of products traded with the rest of the world and the second concept corresponds to the quality of products traded with foreign partners. Devaluation allows increasing price competitiveness to some extent as traded good would be cheaper relatively to competitors. Secondly, competitiveness is always a relative concept. A country, a firm, a football team is always competitive relatively to its partners or competitors.
Come back to the benefits that will induce this increase in competitiveness in southern countries. These competitiveness gains (relatively to the rest of the Eurozone) would permit reigniting growth through the export sector. In fine, renewed growth in southern countries would allow reducing stratospheric unemployment rates observed since the onset of the Euro crisis in 2010.
In this post, we propose to explore different paths through which the Eurozone could reduce competitiveness imbalances. Specifically, we want to highlight that currency devaluation (after an exit of the Eurozone) is not the only way to balance competitiveness in the Eurozone. Indeed, there are several ways to reduce competitiveness imbalances in the Eurozone from a macroeconomic perspective. We will discuss advantages and drawbacks of four different mechanisms that would permit a reduction of competitiveness imbalances in the Eurozone, namely, external devaluation, transfer union, internal devaluation and internal revaluation.
1. External devaluation
We begin with external devaluation, in other words, an exit from the Eurozone to devalue the national currency. This solution is often presented by populist parties as a silver bullet to go out definitively from the Euro crisis. The mechanism is relatively simple with their new devalued currencies; southern countries could boost their exports (thanks to competitiveness gains relatively to the North) towards northern countries and thus reignite growth and reduce their unemployment rates. Advantages of external devaluation are quite appealing, however these advantages could be totally offset by the eventual “whirlpools of speculation” and disruptions in international finance provoked by the announcement of a euro break-up. To sum up, there is considerable uncertainty on the total effect (real and financial) of external devaluation.
2. Transfer union
Another solution could be to implement budgetary transfers to restore competitiveness of struggling countries. This transfer union is always rejected by populist parties as it implies a loss of national sovereignty. If we take the example of France, there are some French regions with obvious problems of competitiveness (relatively to the French average) and unemployment rates that are higher than the national average. We can think to Corsica or to Réunion for example. To maintain the national cohesion, the State transfers funds towards these regions to modernize their productive structures, stabilize their unemployment rates and in fine to join the national average. It is the same problem in the Eurozone! Several “regions” of the Eurozone like Portugal or Greece experienced obvious problems of competitiveness (relatively to the average of the Eurozone) and have unemployment rates largely above the Eurozone average. They could benefit from transfers to modernize their productive structure and then enhance their non-price competitiveness. The problem here is the political legitimacy of such transfers. At the scale of one country like France, richer regions consent to help poorer regions in order to catch-up the rest of the nation. But at the European level, richer countries are reluctant to help poorer countries as they consider these last countries as guilty of laxity and responsible for the crisis. Without political union, this solution will not be discussed. What a pity!
3. Internal devaluation
The privileged mechanism to reduce competitiveness imbalances in the Eurozone since the onset of the crisis has been internal devaluation. Here, the aim is to obtain competitiveness gains through a compression of internal demand (through a freeze of civil servant’s wages for example and more generally through reductions of labor costs) in order to reduce the inflation rate relatively to competitors and thus increase price competitiveness. The mechanism is the same that of external devaluation however there is a large consensus on the fact that internal devaluation is less efficient and more painful than external devaluation. Above all else, politics of internal devaluation implemented by southern countries have not achieved to restore price competitiveness since the reduction of external deficits is due to economic slowdown and a too weak aggregate demand. It’s like the medicine having killed the patient and the doctor was satisfied to have cured the illness!
4. Internal revaluation
A last way to reduce competitiveness imbalances in the Eurozone could be a strategy of internal revaluation. The mechanism is the inverse of an internal devaluation. Germany, by accepting higher price levels and reviving its internal demand thanks to higher wages, could allow boosting growth within the Eurozone and to reduce competitiveness imbalances since the loss price competitiveness will be offset by the very favorable position of German exporters (the well-known Deutsche qualitat). This strategy of internal revaluation could be a way to avoid a deflationary spiral.
The reduction of macroeconomic imbalances seems to be a sine qua none condition to go out definitively from the Euro crisis.
Nota bene: This note has been written with Thomas Coudert and is accessible on the ERMEES website.