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Economic Performance EMU

Achieving Devaluation Inside EMU

There is a fascinating press release from SIPTU (the largest union) today: you can read it here.  The key segments of the press release are:

“Speaking after the meeting, the Union’s General President Jack O’Connor said, “The assault under way is about correcting the problem in the public finances without the wealthy contributing a single cent. It is equally about achieving the adjustment, which would normally be brought about through a currency devaluation, by driving down wages across the private sector as well.”

and

“While a devaluation would affect all sectors of society, cutting pay achieves the same results exclusively at the expense of workers.”

For a member of a monetary union, the analogue of currency devaluation is to engineer a reduction in the general price level relative to the price levels of trading partners (measured in the same currency). This indeed involves a reduction in the inflation-adjusted level of wages across the economy. In relation to the owners of firms, the impact on margins is ambiguous and depends on the structure of each industry. Firms that are exporters and are price takers on world should see an improvement in profitability, as should firms that produce goods and services that are close substitutes with imports. In contrast, firms in ‘nontraded’ sectors may well experience a decline in profitability, especially if these firms use imported inputs.

These considerations are basically similar whether the real devaluation takes the form of a currency devaluation or a decline in the general level of domestic wages and (domestically-influenced) prices.

The major problems with the current situation are:

(i) the national pay agreement is not supporting the attainment of real devaluation. Since the pay increases are still being implemented by ESB, Bank of Ireland and others, the goal of a ‘uniform’ movement in wages across the economy is being inhibited.  It would be better to cancel the existing agreement (the macroeconomic conditions now are far worse than when the deal was reached in September 2008).

(ii)  Wage adjustment is best accompanied by policies to promote competition among firms and, in regulated sectors, to ensure monopoly power is not abused.

(ii) while it is obvious that the overall fiscal adjustment package will require substantial tax increases (including a higher tax take from high income groups), the delay in announcing this component of the deal raises perceptions of unfairness, in addition to increasing uncertainty about the expected level of post-tax incomes for all groups in society. The government could do more in terms of explaining the likely nature of tax increases over the coming years (at least in broad terms). While the Commission on Taxation may have ideas in terms of expanding the tax base, much of the adjustment will be in terms of income taxes and (possibly) VAT.  The general strategy regarding these components could be communicated more quickly.

11 replies on “Achieving Devaluation Inside EMU”

What am I missing here? Are SIPTU suggesting a type of devaluation that I don’t know about? Otherwise their press release betrays a fundamental ignorance of economics, (and the real world) that I find unfathomable.

Philip, I agree with you except for one quibble at the end. Although it is never easy to argue against clariity in government communication, there is an argument for some “constructive ambiguity” in regards to the likely rise in the tax burden.

Some rough figures: We are told we are still facing a fiscal consolidation of roughly 15 billion by 2013. Hopefully, a chunk of that willl be achieved with an economic turnaround (as John Fitz Gearld has encouragingly argued). But let’s be conservative and assume it won’t. Further assume that half of the adjustment will come from increases in income tax. The forecast income tax take for 2009 is 13.2 billion (Budget 2009). Assuming no change in tax bands or no adverse behavioural effects as a result of higher tax rates, that means the standard rate and higher rate would each have to rise by more than 50 percent.

Households are already in a state of shock. How would they react to the expectation of a standard rate over 30 percent and a higher rate over 60 percent. Of course, the higher rate would have to go even higher if the burden is to be lessened for lower earning workers. The unions might think that is wonderfully fair, but it will catch a lot of people. I hasten to add this is not meant to be a forecast. But it does give a sense of the kind of tax increases that people would have to be informed about.

Now it is possible that people are factoring in even higher increases and/or the uncertainty itself is curbing spending. My guess is that people have only a vague sense of what might be in store. Too much clarity could make them retrench even further, which is the last thing the economy needs at the moment. If you are believer in Ricardian Equivalence then of course you believe households see through all this; I see a lot of myopia around, and for once this may be a blessing.

A complication is that it is critical that the bond market sees that fiscal consolidation is coming — and the more clarity there the better. It might be possible to use the Commission on Taxation to make a reasonably credible commitment to raise the tax take without being too explicit now about what that involves.

Philip: you beat me to it, I was going to post on this myself.

I thought that what was interesting was the implicit SIPTU suggestion that the distributional impacts would be different under the two scenarios — interesting, since if that was indeed their concern, then one might begin to start thinking about how to address those concerns.

One way that the distributional consequences are different is that with a devaluation, peoples’ borrowings decline in line with their wages. Another big difference is that any wealth owners foolish enough to leave their assets in the local currency before the devaluation take the same percentage hit as workers. I wonder is that what SIPTU had in mind? And a third, it seems to me, is that with a devaluation the impact effect on real wages is zero, but they are then gradually eroded as prices gradually rise. With a wage cut, the impact effect is that real wages decline by the full percentage amount of the cut, and then hopefully this real wage cut is gradually diminished as prices fall across the economy.

Are there any other distributional differences, and how might this affect the politics of the situation?

I completely agree as regards the pension levy. A simulated devaluation is not only what we need, but it is, by its nature, inclusive, and it addresses the unemployment crisis. Any impact on the government finances can then be presented as a happy by-product of the general wage cuts the situation requires. The way the politics was handled here was unnecessarily divisive IMO.

Kevin, The simulated devaluation is required indeed but in order to maintain the social cohesion of the state there will need to be more careful management of the people’s expectations.

As the Govt. must be seen to act in order to assuage market fears that may or may not be rational so must the govt. assuage the ordinary sean and sinead citizens of this state and demonstrate that every shoulder is indeed to the wheel.

Whether a simulated devaluation does indeed drop incomes for every sector and persons or not is actually immaterial when it comes to securing everyone acting together.

The perception is that the cuts will not affect those who are described in the FT as the denizens of “cosy Irish capitalism”.

What chance then of securing a collective response when most ordinary citizens have such little faith in the the sharing of the burdens and are determined not to be the ones to lose out.

This is a political problem and requires solutions or actions that may seem unnecessary from an economic perspective.

Jer, I must say I didn’t understand why the government wasn’t proposing simultaneous action on, for example, tax shelters. Get the politics wrong and the economics won’t work either. As Philip is suggesting in his post, the incremental nature of government action is probably making it a lot more difficult to get the politics right.

True Kevin and I agree with Philip as well that there is a need to have some more flesh on where this is going.

The tax shelters and various inducements is a good point. An optimist would think that its just a matter of getting around to fixing that problem. A cynic would think that there is no desire to do so if it can be helped. Economically a quid from me or a quid from someone else is pretty much the same but the difference becomes only too apparent on the streets.

John, Your suggestion of constructive ambiguity seems novel in this context. Sounds like “we have nothing to fear but knowledge of what lies ahead”. Is there an empirical or theoretical literature pointing to such a view?

Many writers on the current international crisis argue that self-fulfilling fear of tail risk is a major contributor. In contrast, you suggest that the tail is, and can be kept, concealed from the Irish economic agent.

I would also dispute the implication of your calculations that the needed fiscal adjustment is so out of reach or so potentially wrenching that it cannot be faced up to.

After all, it would be quite foolish to attempt a large increase in income tax receipts by tax rate increases alone: bands, allowances and exemptions would all have to be tackled.

Needed tax adjustments (also in expenditure taxes, etc) are tough but manageable. Large revenue increases can be accomplished without the need to wait for the innovations that might be proposed by the Commission on Taxation. A tentative start was made in the budget of last Autumn with the levies, IMO further consolidation should be planned soon.

Patrick,

I grant you my view here is a bit unusual. If I was wise I would keep it to myself. (You might say that if I was wise I wouldn’t hold it in the first place).

Maybe my perception is distorted by looking at things from the outside. But I see household and business confidence as being a critical variable at the moment. The more confidence declines the more those nasty fiscal measures will be needed. I hate to sound like the Taoiseach, but excessive focus on the negative could be self fulfilling. This is very different from the boom situation, where a bubble needed to burst, and a reality check from economists was well in order. Now we risk overshooting in the other direction.

You are right that my tax example is designed to have a bit of shock value. Sorry for that. But even 25 percent of the adjustment falling on tax rates would be quite a hit, especially if heavily skewed to a rise in the top rate. Even if the burden is spread around with base broadening, there is a lot of extra tax to be paid if this scenario unfolds. The point I am groping towards is that we should be careful not to talk ourselves into it.

As I see it there may be a contradiction between confidence and cyclicality:

1) cyclical considerations would suggest that the bulk of the fiscal contraction should be delayed until the world (and hopefully domestic) economy is recovering, so as to avoid compounding the present collapse of private activity and creating a catostrophic spiral

2) however, the shadow of tomorrow’s fiscal contraction may have an exaggerated affect on activity today because everyone fears being hit by taxes/cuts, even those who ultimately will have had no reason to fear (i.e. maybe corporation tax won’t ultimately rise, but mistaken anticipation of such a rise might cause activity to fall anyway )

Does this suggest that a very detailed plan for the future contraction should be set out now?

I think theres a fundamental diff between an exchange rate devaluation and deflation. Deflation wreaks havoc with economies, esp indebted ones; nominal devaluations do not. Moreover, wages and prices are notoriously rigid; exchange rates are not.

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