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Currency devaluation may look an easy option but it's a trick on workers

VIRTUALLY no academic economist today believes that quitting the euro would be the right thing for Ireland to do: on the contrary, it would be disastrous.

This is despite the fact that in the mid to late 1990s (admittedly, several years after the issue had actually been decided), a vigorous debate emerged among Irish economists regarding whether or not Ireland should enter the European Monetary Union (EMU).

Many, myself included, felt that it was risky to join the EMU and lose the power to devalue the Irish pound: devaluations have worked in Ireland and elsewhere many times in the past, since it is easier to lull workers into accepting lower wages via devaluation, than to convince them to do so in a more explicit fashion.

Everyone agreed that there would be benefits to EMU membership, but there was disagreement about whether and to what extent there would be costs, especially if we entered but the British did not.

A standard way of thinking about these costs is to analyse how an economy such as ours can adjust when faced with a serious economic shock, such as the bursting of a housing bubble, or the sudden depreciation of the currency of our major trading partner. (Or both, as is the case today.)

Even in a relatively well-run state, such shocks will lead to increasing unemployment, and to worsening government finances.

In such a situation, the government is faced with a dilemma: if it raises taxes or cuts expenditure, this will help solve the government's budgetary problems, but exacerbate unemployment.

If it cuts taxes and boosts expenditure, this can help create jobs, but at the expense of worsening the government's budget deficit.

Faced with such dilemmas, governments can oscillate between the two alternatives, leading to "stop-go" policies such as those pursued in Britain during the 1950s and 1960s.

The textbook solution is for governments to tackle their fiscal problems by raising taxes and cutting expenditure, and to simultaneously tackle their unemployment problems by devaluing their currency. Devaluation is essentially a confidence trick, and -- although some economists are reluctant to admit it -- it works.

It works by cutting workers' wages, not by reducing the amount they see on their pay stub every week or month, but by making the currency they are being paid in less valuable. The result is less expensive labour, and therefore more employment.


If devaluation is not possible, what are the alternatives? Theory identifies three. First, unemployed workers can emigrate to countries where there are jobs. This adjustment mechanism has historically been very important in dealing with the consequences of regional booms and busts in the United States.

Second, the state can receive fiscal transfers from abroad. At the time of the debate about EMU, a widely cited estimate had it that when an individual state in the US suffered an income loss of one dollar, nearly 40c of that loss was absorbed by the fact that it paid fewer taxes to, and received extra transfers from, Washington DC.

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Third, wages can fall to the level where firms are willing to hire all available workers. Of course, if wages are this flexible, then unemployment will not be a problem in the first place.

As we can see today, it is difficult to cut nominal wages across an economy (but less difficult in individual companies where workers can see that their jobs are on the line).

So why are most economists against the idea of quitting the euro and devaluing our own currency?

The reason is that, when that currency floats freely against other currencies, as is the case with sterling today, there is no problem: if the central bank cuts interest rates to stimulate the economy, the currency will simply float downwards as an unintended consequence of this action.

But when your currency starts out being fixed against some other currency, devaluation is a tricky business.

Foreign investors will not want to hold Irish currency assets if they believe that those assets are soon going to be worth 10pc or 20pc less.

Once they start to fear that devaluation may be on the cards, they will pull their money out, and the central bank will lose valuable foreign exchange reserves.

However, when you have your own fixed currency, devaluation can be unilaterally decided upon and announced under cover of darkness. A moment's thought suffices to see that this is not possible for a country which wants to exit the euro.

As economist Barry Eichengreen points out, the technical and legal problems associated with switching from one currency to another are immense -- just think of all the planning that accompanied the introduction of the euro in the first place. Laws would have to be passed. Notes and coins would have to be produced. Someone would notice.

In particular, the markets would notice, and they would know the reason you were going to all this trouble was because you wanted to devalue the currency.

No-one would want to hold money in Irish banks, and the result would be an economy-wide bank run.

No-one would want to lend to the Irish Government either, and we know what that would imply. As Eichengreen says, "This would be the mother of all financial crises." So, leaving the EMU is not an option, even setting aside the comparison with Iceland. It shouldn't be considered.

Unfortunately, this has implications for the way in which Ireland can respond to the catastrophic situation in which we now find ourselves.

Tragically, the Government now has to raise taxes and cut expenditure, at precisely the wrong time. It has no choice: if it goes bankrupt, it will end up spending even less.

The right thing to do is to devalue, but that is impossible. Emigration is difficult. And Europe remains fiscally fragmented, so large scale transfers from Brussels do not seem likely (unless the State actually falls over the precipice, which is a prospect that no-one should hope for).

There is therefore no option: we have to try to simulate a devaluation, by cutting wages right across the economy.

The argument that this would lead to economy-wide deflation is specious, since the economy-wide price level that is relevant for us is the European price level, which is unaffected by anything that may or may not happen in this tiny island of ours.

And the cross-country evidence from the Great Depression is unambiguous: the more wages fell during the 1930s, the less output declined.

Our wages are too high relative to our productivity levels, and relative to wages abroad.

They will fall eventually. The only question is whether they do so quickly, or are ground down over the course of a decade or so by lengthening dole queues and a collapsing economy.

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