Friday, 14 January 2011

Devaluing the currency of a country in the Eurozone.

There is a long and thoughtful article by Krugman on Europe here. He deals with the two main problems: debt and lack of competitiveness amongst PIGS.

Towards the end of the article he sets out four solutions, as follows.

1. “Toughing it out”. That is, continue with protracted deflation in PIG countries. (That addresses just the competitiveness problem.) This actually amounts to devaluing the currency of the relevant country, but it’s a slow painful process the way it is currently being done.

2. “Debt restructuring”. That is, debt restructuring while staying in the EZ. (That addresses just the debt problem.)

3. “Full Argentina”. That is, repudiate debts and withdraw from the Euro in the same way as Argentina withdrew from the Peso - dollar peg. (That addresses both the competitiveness and debt problem.)

4. “Revived Europeanism”. This involves Europe becoming more of a genuine social and political union – something like the US.

An example of revived Europeanism is the E-Bond idea. But that won’t happen: it involves Germany and other responsible countries subsidising PIGS or at least apparently subsidising PIGS. If in doubt, mention E-bonds or any other form of permanent subsidy for PIGS to German taxpayers: you’ll get a stiff (and understandable) response.

So barring withdrawal from the Euro, there is only one solution to lack of competitiveness: “Toughing it out”. But as pointed out above, this is a slow painful process. So can the process be speeded up?

There are HUGE gains to be had from speeding up the process. Indeed if the process becomes essentially the same as what I’ll call a GENUINE DEVALUATION (that is devaluation in the case of a country that issues its own currency) the whole process is virtually painless. For example the pound sterling was devalued relative to the US dollar in 2008 by around 25%. Scarcely anyone in the UK noticed. There were a few grumbles about the increased cost of holidays in Florida, and that was about it. There were certainly no riots as per Greece.

Well, here is an idea for speeding up the process. First, raise direct taxes like income tax and reduce sales taxes, like VAT. As in the case of a genuine devaluation, this does not make it any more difficult for citizens of the relevant country to purchase products in the relevant country where those products have little or no import content. Also, as in the case of a genuine devaluation, it’s easier for foreigners to buy products made in the devaluing country.

An alternative and/or supplementary measure to cutting VAT would be to cut the employers’ contribution to a payroll tax (National Insurance contributions in the UK).

And that might just about do the job. To illustrate, VAT in the UK is currently 20%. If that were reduced to zero and income tax were raised, that would constitute a 20% devaluation.

An obvious weakness in this idea is that it cannot be used repeatedly, otherwise one ends up with a negative rate of VAT. But if it were implemented and followed by a wage freeze lasting several years (in nominal terms) plus a freeze on social security benefits, etc., then the idea would work.

Moreover, there is in a sense not much use criticising this idea. This is that, as Krugman rightly points out, the only solution to lack of competitiveness is “toughing it out” or some variation thereon. So for those who don’t like the above VAT idea, here is a question: what better alternative is there?

1 comment:

  1. #1 will not work
    they are not going to be more competitive by lowering their labor costs, sounds like great depression to me
    private sector debt is going to start to default, deficits will be there to bail out banks just like in Ireland. To bail out banks you don't need any real resources just like they did It in US. If they go by the book in euroland then Ireland is going to pay for the bank bailout with exports. For the bailout that didn't need real resources?


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