This is the year when the economic experiment of the Fine Gael/Labour coalition and their partners in the IMF/ECB/EU commission will be put to the test. The continuation of the experiment has failed thus far and there is little reason to expect it will succeed in 2012 or 2013. This experiment can be described as an attempt to adjust the economy via an internal devaluation. So, what is an internal devaluation, has it been tried before and why am I so convinced it will end in total failure?
An internal devaluation is the attempt to reduce costs in the economy without adjusting exchange rates by driving down wages and public spending. Ireland cannot make the price of its currency cheaper because it is outside the control of the Irish Central Bank (ICB). It belongs to the European Central Bank (ECB)who are independent but sensitive to the interests of much larger and more important economies than Ireland i.e. Germany and France. According to the leading economic expert on the European Monetary Union, Paul de Grauwe, this inability to adjust the exchange rate in response to a massive economic crisis means that countries like Ireland, in effect, are operating under a foreign currency.
The purpose of a currency devaluation is to make an economy competitive by offsetting costs to your trading partners. It is far from ideal but has been used extensively throughout European history for weaker economies to regain competitiveness. The objective is to increase exports by making them cheaper. So, in Ireland, a devaluation would reduce the purchasing power of your savings and wages relative to other countries but simultaneously boost exports and reduce debt. The collective outcome is a reduction in debt and an increase in GDP. These are core indicators by financial markets when assessing the capacity of a country to remain solvent. Iceland has adopted this course of action and contrary to what one hears in the mainstream Irish media they are recovering much faster than Ireland.
This is not a controversial argument. It is common sense to anyone who understands the basics of macroeconomics. A country with the capacity to devalue their currency will recover faster than a country that does not. So, can an internal devaluation do the same? This, as stated earlier, is the attempt to achieve what a currency devaluation does through a longer and more arduous process of driving down wages and public spending. The purpose is to make exports more competitive by making labour costs, rather than the currency, cheaper.
A currency devaluation shifts the burden of adjustment on to monetary policy whilst an internal devaluation shifts the burden on to labour market and fiscal policy. Monetary policy is technocratic and outside political contention. No one challenged the government over the 1986 and 1992 devaluation. An internal devaluation is political, deeply contested and therefore much more difficult to achieve. But, can driving down wages and public spending actually work? Will it actually solve Ireland’s economic problems?
The answer to the first question is a definitive no. Since 2008, Ireland has not driven down wages or public spending to the level that would be required in the radical theory of internal devaluation. Wages have been brought down in some sectors and in some firms. But, in general, Irish employers have responded to the crisis by cutting jobs not working hours or wages . Only the government, as employer, have imposed a general wage cut as a strategy to avoid layoffs.
Few, if any, employees have taken legal action against the non-payment of wages act (which makes it illegal to cut wages without negotiated agreement). Most employees in a context of 14 percent unemployment would accept a 3 percent pay cut over losing their job. But, for employers, it is easier given the absence of labour market coordination to reduce costs through layoffs. This might be rational for an individual firm but the collective impact across society is an employment crisis. Contrary to economic orthodoxy, it is those economies with regulated and coordinated labour markets (i.e. not flexible) that have weathered the employment storm better because employers are forced to pursue job cuts as a last not a first option.
The general point is that an internal devaluation (the implicit policy of the Irish government) drives up unemployment rather than driving down labour costs Therefore, the policy of creating jobs whilst pursuing an internal devaluation is a contradiction in terms.
But, even if employers drove down all wages by 30 percent, would this have the actual desired effect of stimulating exports? Again, the answer to this question is a definitive no. Taking that much purchasing power out of the domestic economy would depress economic demand and lead to further job losses, shop closures and general stagnation. This is common sense and most honest economists would admit this (even if their deductive models do not).
But, will the second component of internal devaluation, a reduction in public spending work? Ireland has advanced this more than any western economy. It has reduced spending on public sector pay, healthcare, eduction, social welfare and capital investment by more than any other European country. In fact, the level of reduction in public expenditure (current and capital) has led to an adjustment of 14 percent of GNP, which according to the IMF, is the largest ever recorded in the history of western capitalism. But, this is still not enough to achieve what would be required by an internal devaluation.
This radical agenda, being stoked by the irrationality of financial markets, has not and will not work. The deficit remains persistently high and the debt-GNP ratio is growing. Why? Because, taking that much money out of an economy, historically dependent on non-traded sectors of the economy (public sector, construction, legal professions and domestic retail) inevitably leads to a contraction in domestic demand. This is common sense. Most European policy makers know it wont work but to be quite frank, they don’t care. Ireland accounts for less than 1 percent of European GDP. As long as we don’t let the banks fail, stick with the Euro and shift the burden of adjustment on to taxpayers, they will keep their head in the sand.
It is for this reason that we need strong domestic political leadership with the courage to announce and recognise that the experiment has failed. There is a strong possibility that in 2012 Ireland will have a referendum on the new proposed EU fiscal treaty. This, according to the finance minister, Michael Noonan, will be a referendum on the Ireland’s future in the Euro. Those who oppose the treaty (and by default, Ireland’s continuation in the Euro and internal devaluation) will be denounced as irresponsible, crazy, anti-European and radical. Whilst those who support the treaty and Ireland’s participation in the Euro will be presented as rational, level-headed and committed to Europe.
However, it is the radical agenda of pursuing the unprecedented economic adjustment via internal devaluation that is crazy, irresponsible and likely to increase anti-European sentiment in Ireland. Neither the government nor a conservative media establishment will tell the public about this implicit high risk strategy because they dont fully understand what they are doing. They are willing to be bullied by the dicatorship of financial markets. It is high time that the real Europeans stood up and said enough is enough. The strategy is not working. We need a new approach to integration and it has to be premised on solidarity not austerity.