Wednesday, January 4, 2012

No light at the end of the tunnel - fiscal austerity Vs currency devaluation

I blogged a few days back about why currency devaluation is the most effective route to regain competitiveness. David McWilliams has an excellent graphic that captures the power of external devaluation.

The graphic reveals both the reality and the counter-factual. After it sharply devalued its currency in late 2008, Iceland's wages fell sharply and it quickly regained its labour competitiveness. The counterfactual - if Iceland had remained within Eurozone - is indicated by the Icelandic wages with respect to Euro, which would have remained very high. So McWilliams advocates an exit from Eurozone for Ireland as the "least extreme option".

"Iceland in one sharp devaluation has achieved what Ireland and Latvia are supposed to achieve over years of grinding down wages. If we are supposed to achieve Icelandic levels of wage competitiveness, we will have to shrink the economy over the next few years. By having their own currency the Icelandics did in a few weeks what we have been trying — unsucessfully — to do over four years... no economy in the world has ever emerged from a recession like ours without changing its exchange rate. The reason is that it simply can’t be done. There is no evidence anywhere, ever, that shows that a country can operate a successful “internal devaluation” — particularly an economy carrying as much debt as we have."

The belief that fiscal austerity would generate contractionary expansion is yet another example of failure to think beyond stage one. In fact, McWilliams himself provides the explanation as to why internal devaluation cannot work,

"When people are laid off, it is very difficult to get a new job because no one is spending in the economy. The government is not spending and the people are not spending. But what about the the much heralded export-led growth which postulates that foreigners will buy loads of Irish goods, more than compensating for the fall in domestic spending?

Well it doesn’t happen, partly because Irish wages don’t fall as we can see in the chart, so Irish goods are no more competitive than they were a few years ago. Yes, exports have risen, but nowhere near enough to offset the local contraction. This is why unemployment has trebled in three years and why emigration is running at over 1,000 people a week. It is not that the policy of internal devaluation is not working, it can’t work. It has never worked anywhere, ever."

Massive cuts to public expenditure and social protection, wage freezes, and tax increases mean that Ireland has been subjected to one of the most severest austerity programs. As Guardian reported, fiscal adjustment in Austerity's Child is the equivalent of €4,600 per person, the largest budgetary adjustments seen in the advanced economic world in recent times. Annual adjustments of €3-4 bn are proposed until 2015. The evidence in favor of contractionary expansion is surely missing.

News from Spain, another country experimenting with fiscal austerity, too is dismal. Spain's plight is a representative of the slippery slope associated with fiscal austerity. As austerity bites, aggregate demand slumps, and public revenues fall, the deficit widens and the debt-to-GDP ratio increases. Another danger is that once the fiscal consolidation targets are announced and if governments fail to meet them, the bond markets will react adversely, thereby raising the yields on sovereign bonds.

Spain’s new prime minister, Mariano Rajoy, last week admitted that the country faced wider than expected budget defict (it is estimated to be atleast two percentage points higher above the government's target of 6%) and announced a further package of austerity involving tax increases and spending cuts amounting to $19.3 billion. This is deemed necessary to maintain bond market confidence.

Though it is on target to cut the budget deficit by €16.5bn (£14bn) in 2012 through sweeping cuts, it is now being estimated that the economy will contract up to 0.3% in the final three months of 2011 and again in the first quarter of the new year. Its unemployment rate at 21.5% is already the highest in Europe and youth unemployment rate is at a whopping 45%.

Spain's problems come from the serious budget shortfalls faced by its 17 autonomous regions which have spent recklessly in the past decade and continues to do so. As a Times report writes, in recent years, the regions and municipalities have racked up debts, offering generous public services and investing in a wide range of projects, some of them bordering on the ridiculous. The Bank of Spain recently announced that regional debt had surged 22% to $176 billion in September from $144 billion the year before. And there is a strong feeling that there remain tens of billions of dollars in 'hidden' regional debt yet to be discovered.

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