Thursday, December 15, 2011

Policies to Improve Eurozone economy

Readers Question: I read a lot about two suggested solutions to the Euro zone that seem to contradict each other:
  1. Internal devaluation to restore competitiveness (which means wage and price deflation).
  2. Create more inflation that will reduce debt overhang in real terms.

If you choose to 'deflate' you will gain competitiveness but will also increase debts in real terms, which could discourage spending. On the other hand, inflating debts will reduce them in real terms, but will further hurt competitiveness. How do you reconcile the two?

Internal Devaluation

At the moment, the Eurozone is choosing option one - internal devaluation.

There are many factors which are pushing Eurozone inflation lower.

  • Spending cuts and attempts to reduce budget deficits.
  • Wage freezes or wage cuts put downward pressure on wage inflation.
  • Countries which are uncompetitive can't devalue to improve competitiveness. Therefore, inflation is pushed lower.

The problem for the Eurozone is that many Eurozone economies face substantially higher costs and uncompetitiveness. Spain, Italy and Greece are perhaps 20% overvalued. To restore competitiveness by internal devaluation means they face several years of low growth, high unemployment and social unrest.

Deflation increases Real Value of Debt

Yes, you are correct that deflation, would increase the real value of debt. Deflation will, ceteris paribus, increased debt to GDP ratios in these countries. They will have to devote more tax revenue to interest payments. It becomes a vicious cycle of austerity, lower growth and lower tax revenues.

If they had their own currency (like Iceland or UK) they could immediately restore competitiveness through a devaluation.

Eventually, internal devaluation will help to restore competitiveness and their will be economic growth of sorts. This process can be quicker and less painful if

  • Labour markets are flexible
  • Supply side policies to increase labour productivity and flexibility
  • The working population agrees to the austerity

So far, Ireland has been less prone to striking than Greece or Italy.


I would say the policy is not so much just to create inflation, but to put a higher priority on increasing nominal GDP, even if it leads to a little inflation. This may involve more expansionary monetary and fiscal policy. (i.e. not increasing interest rates in 2011 like ECB did).
The benefits of targeting higher nominal GDP
  • Debt to GDP ratios reduce
  • Higher economic growth helps reduce budget deficit in a much less painful way than spending cuts.
  • Arguably, higher growth and tackling EU's chronic unemployment problem should be the highest priority.

There are risks involved in targeting higher inflation. If inflation became deep-seated it does have costs and can be difficult to reduce. But, at the moment, inflation is not a problem. Core-inflation is below target, and in 2012, there are only going to be more deflationary pressures.

See: Inflating away our debt

Combination of Policies

I feel the Eurozone needs a combination of policies

  1. Target higher economic growth (higher nominal and real GDP)
  2. Reduce pace of fiscal austerity (ECB should buy bonds and create money to reduce pressure for immediate spending cuts)
  3. Supply side reforms to improve labour market flexibility in southern Europe.
  4. Long term fiscal change which deals with long-term spending entitlements (e.g. higher pension age) will help improve long-term structural deficit without harming current growth.

The best solution would be higher economic growth, combined with increased productivity amongst uncompetitive countries. But, the problem is in a single currency, to actually restore competitiveness through internal devaluation takes a long time.

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