Internal Devaluation and the Crisis in Europe

The Euro area is entering recession again. It’s tempting to call this a double-dip recession, but that would be misleading because the first recession never really ended: the EU’s output is still below the pre-crisis peak. But still, things are getting worse. It is the Southern European countries and Ireland that are dragging down European growth; but the recession in Europe’s South is now also beginning pull Germany down.

Europe’s answer to the crisis has been an orthodox one: sound public finance and ‘internal devaluation’. Internal devaluation is the modern way of saying ‘cut wages’. And this is precisely what the Southern European countries have done. In Greece real wages have fallen by no less than 17% since 2008. In Portugal by 4.5%. In Spain and Italy they fell by about half a percentage point and in Cyprus by 1.4%. Among the Western European countries in recession only in Ireland are real wages higher than they were in 2008 (there they increased until 2009 and declined thereafter).

Source: AMECO database; real GDP, real wages and Prices (GDP deflator) are %-changes from 2008 to 2012; unemployment rate: % in 2012

Have these sacrifices in the living standards done any good? The answer is no. Unemployment has been rising in all these countries. The unemployment rate is 23.6% in Greece and 25% in Spain; it is around 15% in Ireland and Portugal and above 10% in Italy and Cyprus.

Have they at least been able to improve their competitiveness compared to Germany? The answer is barely. Greece has had virtually the same inflation (measured by the GDP deflator) as Germany; Italy and Cyprus had even higher inflation rates. Portugal’s price level increased by 1.2%-points less than Germany’s and Spain’s by 2.5% less. Only Ireland’s competitiveness has improved substantially. But these gains are miniscule compared to the gain in competitiveness of Germany of some 25% and more in the decade since the introduction of the Euro.

In short, the internal devaluation strategy is not working. Wage cuts are not stimulating the economy and they are not increasing employment. Rather they are aggravating the lack of aggregate demand by reducing consumption expenditures while the wage cut might succeed to stimulate external demand in some European countries if they were carried out in isolation. But in fact, half of Europe is cutting wages at the same time (and in the other half wages are growing very modestly as well). European countries are mostly trading among each other, when all of them cut wages at the same time, none can substantially increase net exports, but all suffer from shrinking consumption.

So what should Europe do instead? Europe has two problems. Firstly, a recession. In order to counteract a recession expansionary fiscal policy is necessary – that means more government spending, not less. These should be financed by the European Union rather than via individual countries because since individual countries have adopted the euro, they cannot self-finance without the interest payments on their debt rising. Second, Europe has a problem of imbalances across its member states. These should be tackled via inflationary adjustment in the (trade) surplus countries. Instead of deflation in the South, Europe needs inflation in the centre. Or to put it in simpler terms: Europe needs a hefty dose of wage increases in Germany. That would be the only way of rebalancing without strangulating the Southern European countries.