Report Influence

  • In depth assessment of the Eurozone’s overriding response to a key plank of the crisis via in internal devaluation– correctly highlighting that the progress is half complete in many cases.
  • Correctly predicted that while internal devaluation can be successful, it is inherently more difficult in the Eurozone as the political and social costs may prove too high for the Eurozone periphery to bear.


Austerity and cuts: The Eurozone periphery's plummeting trust in the EU (2001-2012)

Trust in the EU is plummeting in the Eurozone's periphery following years of EU and IMF-mandated cuts. In the past, ‘Europe’ was seen as a stable counterforce to unpredictable national politics, but now, only 25% voters in the Eurozone's periphery say they trust the EU: down from 50% in 2012. This raises the question whether the policy of 'internal devaluation' will be too much for voters to bear.Source: Eurostat

10 September 2012

Internal devaluation vs currency devaluation

Struggling countries in the Eurozone – Portugal, Italy, Ireland, Greece and Spain  – do not have the option of currency devaluation to get their economies back on track. All adjustment must instead be achieved by nominal prices, wages and asset values falling – so-called ‘internal devaluation’. This means that the population will have to pick up all the slack through falling wages, fewer social benefits and less job security. Therefore, the risk of political and social fallout – through strikes, riots or even wider political unrest – increases massively.

It is clear that the Eurozone periphery needs to undergo far-reaching structural reforms to improve their labour and product markets in order to regain competitiveness. Failing this, the stronger euro countries will be paying for the weaker ones indefinitely in a transfer union. The alternative is a Eurozone break-up.

Spain, Italy and Ireland, in particular, can still in theory achieve the internal devaluation needed to become reasonably competitive with Germany. By 2011, Spain had achieved over 50% of its scheduled internal devaluation, while Ireland has managed over 80% and Italy has to reduce its labour costs by another 10% (although it is yet to put the policies in place to do so). However, Portugal is a borderline case (having achieved 40% of its scheduled adjustment) as, along with Greece, it is unclear whether it will be able to make the necessary cost reductions needed.

Is internal devaluation the right policy?

The experiences of the Baltic states show that large-scale internal devaluation is both economically possible and desirable, in terms of returning to economic growth. However, the Baltics’ adjustment was preceded by very rapid GDP growth. Significant contraction in wages and GDP had less perceived effect since the population had yet to consider the pre-crisis standard of living as the norm. In contrast, in Greece and Spain, high wages, social benefits and public services have been a feature of life for decades, meaning that it is far more challenging to get voters to accept anything less.

To illustrate the political challenge at hand: a 17% contraction in Greek real GDP by 2013 (expected by the IMF) puts Greece back to 2002, meaning that Greek GDP per capita will have fallen from over €16,000 in 2007/8 to under €13,000. Similarly, a 20% reduction in the Portuguese economy would take it back below its 1995 level of output, a reversal of 17 years – almost an entire generation lost.

The question is whether the populations in the struggling Eurozone periphery will be willing and able to accept such rapid adjustments. There is no certainty as to when the political limit for cuts and austerity will be reached. However, protests on the streets of Athens and Lisbon, and widespread discontent in Spain, illustrate that the limit may not be far away.

In the wake of EU/IMF-mandated cuts, perhaps the most worrying trend in the Eurozone periphery is that trust in the EU is plummeting. In the past, ‘Europe’ has been seen as a stable counterforce to unpredictable national politics but, on average, trust in the EU amongst voters in the Eurozone’s periphery has fallen from 55% in 2001 to 25% in 2012.

If both the EU and national politicians are so deeply mistrusted by voters, it is difficult to see how politicians will have the mandate to continue to pursue internal devaluation. Large-scale internal devaluation is economically necessary but may prove to be politically explosive, at least under the current timeframe envisaged. Crucially, all other existing currency unions also rely on a common fiscal backstop, therefore, although internal devaluation is necessary, alone, it is unlikely to be sufficient to solve the Eurozone crisis. 

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