The European Union is fertile testing ground for political economics. Internal devaluation – the reduction of trade imbalances by cutting wages – is set to follow other innovations such as having a single currency with multiple fiscal authorities. In theory, the technique should work well. In practice, the outcome is harder to call.
Individual members of the euro zone cannot make their exports cheaper by devaluing their currencies. But they can, theoretically at least, produce the same effects by systematic wage cuts, which in turn reduce costs and domestic prices. Portugal is trying this out on a tiny scale, by lowering taxes on labour. Greece, which has few strong export industries, will need something much more substantial to eliminate its balance of payments deficit. It stood at 12 percent of GDP in the first half of 2011.
Will it work? No one really knows, because the precedents are so sketchy. German labour costs fell after the export powerhouse started to run trade deficits in the second half of the 1990s. Germany now has a big trade surplus again, but this might have come about simply as the country reverted to it normal state of health. Greece has no such rosy past.
The other precedent is Latvia, which has its own currency but embarked on a rigorous post-bubble recovery plan based on an internal devaluation of 10-20 percent. The IMF, which is calling the shots in the Baltic state, thinks it is working. Latvian GDP is expected to grow 3 percent this year after declining by almost a quarter in the previous three. But critics reckon the country is teetering on the edge of economic and possibly political disaster.
For an internal devaluation to work, it has to stimulate economic activity without spawning social discontent. Success requires a strong shared sense of national purpose – something noticeably lacking in Greece. But as the Hellenic state falls behind on its austerity targets and creditors lose patience, its only realistic choice is between two first-time experiments. A big internal devaluation? Or a regular one resulting from a euro exit? The internal option looks less hazardous.