international analysis and commentary

Fiscal devaluation for the euro countries? The wrong solution


While the US is recovering from its recession (despite many gloomy predictions) and most emerging economies are still growing (although at lower rates), the persistent sovereign debt crisis seems to offer no short-term hope for Europe. Austerity measures have further depressed already low domestic consumption and investments in innovation. The continuing crisis has spurred European governments, especially in the southern part of the continent, to invoke a weaker euro. As the European Central Bank (ECB) has not been receptive, a few governments and some analysts have started looking at the so-called “fiscal devaluation”. Such a measure would be counter-productive by temporarily providing companies with a comparative advantage but also delaying reforms that are badly needed in the Southern European economies to improve competitiveness.

The declining innovation ratio experienced in Europe over the past years has harmed potential gains in per capita productivity, thus limiting economic growth. To help solve this crucial problem, a traditional policy option would be to adopt expansionary monetary policies, aimed at relaunching growth, at the price of higher inflation, but also causing a capital outflow toward emerging economies.

As is well known, countries belonging to the eurozone, and affected by high debts, have been forced to adopt austerity plans with the aim to restructure their economies: although the purpose of these plans was absolutely laudable, the burden in the short term has been very heavy indeed.

In addition, the current debt structure does not give the ECB much flexibility on the exchange rate. Although a weaker euro could make low added value industries more competitive, the common currency cannot be traded below 1.26/1.28 against the dollar – some analysts say even 1.22 – otherwise holders of Southern European country bonds would sell these immediately to avoid a net loss due to the new exchange rate.

This is where the so-called “fiscal devaluation” has come into play. French President François Hollande opted for a surge in consumption taxes to fund a tax credit on payroll, leading to an internal devaluation. Raising value added (VAT) and cutting payroll taxes produces some of the effects of currency devaluation. The higher VAT makes imported goods more expensive as foreign companies exporting to the country have to pay duties on their products. Simultaneously lowering payroll taxes allows domestic companies to offset the higher VAT while not raising prices. Because domestic company exports are not subject to VAT, they can sell their products abroad at a lower price – exactly as if the euro had been devalued.

President Hollande’s proposal to raise the two highest VAT rates offsetting a €20 billion tax cut on certain payrolls generated a lot of interest in Mediterranean countries – considering their tradition of competitive currency devaluations prior to joining the euro. Although some analysts believe such a policy can potentially generate higher tax revenues for governments, in reality it is a threat to the long-term competitiveness of these countries.

First of all, we cannot take it for granted that entrepreneurs, receiving the payroll tax credit, will use it to reduce prices and sell more abroad. Second, as other countries are likely to react at least in the medium term, a trade war becomes likely, further reducing the positive effects of the devaluation measures. In particular, Southern European companies cannot compete indefinitely with producers based in emerging countries that continue to have much lower labor costs.

Instead of looking to old solutions to old problems, Southern Europe should put innovation at the center of their policies. The key measures are those that encourage investments in high value added goods and services, such as support for R&D tax credits for high-tech companies, cuts in domestic energy consumption through conservation and transformation.

Foreign direct investment in several South European countries has been falling dramatically since the onset of the international financial crisis and then the euro crisis. More and more investors are relocating their assets and investments to emerging markets. As foreign companies have historically represented the bulk of investments in innovation, this is a truly worrisome sign. It should also be a wake-up call for decision makers to start focusing on the core objective: not growth at any cost, but through reforms that spur innovation and competitiveness.