Internal devaluation during euro crisis had ‘limited effectiveness’

The policy of internal devaluation in response to the eurozone debt crisis has had only limited effectiveness, according to two World Bank economists.

“The evidence suggests that the policies of internal devaluation implemented in the periphery, with the aim of boosting external competitiveness by curtailing labour costs, may have had only limited effectiveness in restoring the external balance to equilibrium,” said economists José Luiz Diaz Sanchez and Aristomene Varoudakis.

“Internal devaluation may have certainly contributed to a contraction of domestic demand and, through this channel, may have helped absorb external imbalances in the eurozone periphery. However, an unintended consequence of this correction has been a potentially large redistribution of income at the expense of wage earners in the periphery.”

The causes and response to the eurozone debt crisis ratcheted up tensions between core and periphery countries over the past few years.

According to the German government in particular, the cause of the debt crisis in Ireland and southern EU countries stemmed from a loss of competitiveness.

Berlin has insisted that in return for financial assistance, programme countries had to accept sweeping reforms in order to boost competitiveness. Internal devaluation, which means a cut to wages and salaries and a knock-on drop in living standards, has been a big part of the structural reforms introduced in Ireland, Greece, Spain, Portugal, and Italy.

There has been a huge backlash against internal devaluation policies in these countries, which is expected to lead to a rise in anti-euro parties at the European Parliament elections in May.

Mr Sanchez and Mr Varoudakis, in a paper called, Tracking the causes of the eurozone external imbalances: New evidence, found that rapid growth in domestic consumption on the back of a credit splurge caused by eurozone financial market integration was the main cause of the debt crisis among periphery countries.

Greater mutual surveillance of fiscal policy and tighter control of credit markets are needed for more effective economic management of the region in the future, although both authors noted that Brussels had introduced legislation covering these areas.

“To be sure, improvements in external competitiveness matter and can boost real GDP growth. Structural reforms that improve the business environment and investments that enhance productivity hold the key to external rebalancing and stronger medium-term growth.

“This broader structural reform agenda, as well as complementary, productivity-enhancing public investments in physical and human capital, should not be lost from sight by the focus on labour cost competitiveness as a remedy to external imbalances in the drive to prevent future crises.”