Friday, June 17, 2011

Is internal devaluation enough for Europe? Probably not, very unlikely...No

The IMF produced an interesting paper, "Euro Area Export Performance and Competitiveness", that could have policy implications for the effectiveness of internal devaluation on intra-Euro area export demand. As I interpret Table 1, page 13, intra-Euro area exports are less sensitive to foreign demand (like German demand for Spanish exports, for example) and more sensitive to measures of 'competitiveness' than are extra-Euro area exports.

One could argue the following: these results demonstrate that internal devaluation has a better chance of working for trade within the Euro area than it would for other countries that aren't part of a single-currency union. The policy implication is that gained relative competitiveness via fiscal austerity in Spain, Greece, and Ireland has a fighting chance to produce a positive growth outcome. (If you want to skip to the end of this article, I present another interpretation of the results.)

We are seeing some evidence already of the link between internal devaluation and the rebalancing of trade within the Euro area (data link). The chart below illustrates the shift in the trade balances on a rolling 12-month basis and as a share of GDP across key Euro area countries (click to enlarge).

Generally, the healthy rebalancing is occurring on a trended basis. The intra-Euro area trade deficit is worsening in some of the core countries, like France and even Germany, and improving in key Periphery countries, most notably Spain and Greece. This is what is supposed to happen: capital moves away from the Periphery and into the core, eventually driving the trade flows to a healthier and more sustainable flux.

However, there's another way to read the results of Table 1 (page 13): the elasticities of real export volume with respect to the real exchange rate (i.e., measures of competitiveness, and however you measure it) are all less than one (except for one case). That means, for each 1% increase in relative competitiveness, export volume rises by less than 1% - and in some cases a lot less than 1%.

Simply put: the Periphery countries need an inordinate amount of internal devaluation and fiscal austerity to derive sufficient real export growth. Without the strong impetus to global demand, the necessary internal devaluation then becomes 'infernal'.

I haven't quantified this result; but the illustration above suggests that much more is needed. Furthermore, with global growth slowing - the IMF just today lowered its growth forecast - I'd say the Periphery countries will be showing some serious 'economic holes' in coming quarters.

Rebecca Wilder


  1. Patrick VB, Brussels BelgiumJune 18, 2011 at 4:52 AM

    <span>Hello Rebecca, the intra-euro trade chart you provide seems to offer some hope... However, the data is for net trade flows. A negative trade balance, like the one in Greece, could become smaller just through a contraction in imports, without implying any pickup in Greek exports... Thanks for the allways interesting posts!

  2. I’m a bit doubtful about the idea that devaluations don’t work. Wynne Godley always claimed it didn’t work for the UK. And JKA of makes the same claim.

    On the other hand what has kept European countries’s balance of payments roughly in balance over the last century? It’s been the relative value of their currencies isn’t it? Some countries have had to go for significant amounts of emigration as a solution, e.g. Italy and Ireland, but they are the exceptions.

  3. Hi Patrick,

    You are right, in the case of Greece, especially, and Portugal, too (not really spain on a trended basis), much of the improvement of the trade balance has occurred on the back of a crunch in import demand. The drop in aggregate demand from fiscal austerity is deflationary, as capital flows rebalance out of the Periphery and in to the core. The positive effects on exports occurs only at a lag - the problem is, money is tight and the global expansion is slowing, so there's not enough time. These two factors make the great European experiment futile.


  4. Hi Ralph,

    There are several conditions that need to be met in order for internal devaluation to work (Canada in 1995 is a good example of this):
    1. Loose and loosening monetary policy
    2. Strong global momentum, i.e., strong external demand for export income.
    3. Nominal devaluation that drives the real exchange rate even lower.
    See, it's possible, but Europe has really only one of these factors (2.), and even that's slowing now (look at US momentum). The UK in 2007-current had nominal devaluation and eventually strong global momentum. However, now it's economy is showing serious holes.

    My point is, not even nominal devaluation guarantees that internal devaluation (in this case, fiscal austerity) works. You have to consider the private sector desire to save - that's high in the cases of the UK and Periphery Europe.

    You need all of the stars to line up for internal devaluation to work - Europe is far from seeing this.


  5. The Netherlands maintains low unemployment with a work week of 28 hours, up from 26 in 2007.  That's a better austerity program than tax cuts for the rich and tax hikes for the poor.


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