Fiscal devaluation – a terrible idea that will never work

Maybe I am ignorant, but until recently I had never heard of the concept “fiscal devaluation” (at least not that term), but I fear it could be an idea that could have considerable political appeal, but as I understand the idea it smells of protectionism and the idea is based on a mis-diagnosing the reasons for the present crisis – particularly in the euro zone.

What is a “fiscal devaluation”?

The idea behind fiscal devaluations is that a nation can improve it’s competitiveness by basically “twisting” taxes by cutting payroll taxes and finance it by increasing VAT.

The idea is not new. Already back in 1931 John Maynard Keynes suggested a VAT style tariff on all imported goods plus a uniform subsidy on all exports. In 2011 the idea was re-introduced by Gita Gopinath, Emmanuel Farhi and Oleg Itskhoki in their paper “Fiscal Devaluations”.

I will not go through the paper (and it the idea I want to discuss rather than the specific paper), but rather discuss why I find the idea terrible and why I think it will not achieve any of the results suggested by it’s proponents.

Fiscal devaluation is protectionism

The first thing that came to my mind when I heard the description of a fiscal devaluation was that this is basically a typically 1930s style protectionist idea: Tax imports and subsidies exports. Anybody who have studied economics should know that protectionism is extremely negative for everybody and such protectionist ideas will lower the economic welfare of the country that introduces the protectionist measures and of other countries. Only fools advocate protectionism.

Furthermore, I am completely unaware of any countries that came out of the Great Depression through a fiscal devaluation, but I know of many countries that tried. This is an idea that have been tried before and failed before. So why try it again? However, I can easily find numerous examples of countries that have undertaken proper (monetary) devaluations and have succeed. The UK and the “Sterling bloc” in 1931, the US in 1933, Sweden in 1992 and Argentina in 2002. The list is much longer…

The point is that a fiscal devaluation is negative sum game – it hurts everybody – while a monetary devaluation is a positive sum game if the world is caught in a quasi-deflationary environment as has been the case for the last 4-5 years. As I have stress before a monetary devaluation is not a hostile act – a fiscal devaluation certainly is.

Mis-diagnosing the problem

A key problem for the Fiscal devaluationists in my view is that they mis-diagnose the problem in for example South Europe as a problem of competitiveness rather than a problem of weak domestic demand. In that sense it is paradoxical that origin of the idea comes from Keynes.

It might of course be that South Europe has a competitiveness problem in the sense that the real exchange rate is “overvalued”. However, competitiveness does not determine aggregate demand. The real exchange rate determines the composition of aggregate demand, but not the aggregate demand. Aggregate demand is determined by monetary policy. And the lack of aggregate demand is Greece’s (and the other PIIGS’) real problem. The euro crisis is not a competitiveness problem, but a NGDP crisis.

Countries with fixed exchange rates or countries – like Spain or Portugal – that are in currency unions are not able to ease monetary policy as the have “outsourced” their monetary policy – in the case of Spain and Portugal to the ECB. A fiscal devaluation is unable to ease monetary policy – at the most it can only “twist” demand from domestic demand to exports (…there is a small aber dabei – see PPS below). In that sense a fiscal devaluation is mercantilist idea – an idea that exports in some way is “better” than domestic demand.

However, artificially twisting demand from domestic demand reduces the international division of labour. It might be that Keynes or the average German policy maker think that is a great idea, but Adam Smith and David Ricardo are spinning in their graves.

There is only one way out of a quasi-deflationary trap – monetary easing

For countries caught in a quasi-deflationary trap – as the South European countries – a fiscal devaluation might temporarily improve external balances, but it will not do anything about the deflationary pressures. There are only two options for these countries – either they leave the euro or the ECB ease monetary conditions.

Lower taxes is great for long-run growth – twisting taxes is mostly a waste of time

Finally I would like to stress that I in no way is arguing against lowering payroll taxes. However, the purpose of lowering payroll taxes should not be to increase export, but to remove a tax wedge that lowers employment. Lower payroll taxes very likely will increase the level of potential GDP (but not impact nominal GDP). Furthermore, I doubt that higher VAT would be beneficial to any country in the world. Even worse if the central bank – like the ECB – targets headline CPI-inflation then higher VAT rates will temporarily increase headline inflation and that could trigger a monetary tightening. If you think that is alarmist – then just think about what happened when a number of euro zone countries started to increase indirect taxes in 2010-11 at the same time oil prices spiked. The ECB hiked interest rates twice in 2011!

Reading recommendation for policy makers

Concluding, fiscal devaluation is a terrible idea and we should call it what it is – protectionism – and any policy maker out there who is tempted by these ideas should carefully study the experience of the 1930s. The best way to learn about the serious welfare cost of this sort of ideas is to read Doug Irwin’s excellent little book Trade Policy Disaster.

In his book Doug clearly shows that fiscal devaluation style measures never worked but helped escalate trade wars while proper monetary devaluations helped countries like the US, the UK and Sweden get out of the Great Depression.

You could also read Chapter 10 in Larry White’s great book Clashes of Economic Ideas. In that chapter Larry explains the disaster that was economic policy in India in the first 4-5 decades after Indian independence in 1947. India of course pursued (and to a large extent still do) the kind of policies that the fiscal devaluationistists advocate. The result of course was decades of lacklustre growth.

So before policy makers are tempted by protectionist ideas packaged in modern New Keynesian models they should study history and then they should realize that “fiscal devaluation” is terrible idea that will never work.

PS Maybe it is not a surprise that the French government – yes the government that introduced a 75% marginal income tax (!) – find a fiscal devaluation attractive.

PPS I write above that improving competitiveness cannot ease monetary conditions. That is not entirely right as anybody who knows Hume’s traditional price-specie-flow mechanism would acknowledge, but that is at best a very indirect channel and is very unlikely to be very powerful. In fact there has been a quite drastic improvement in external balance in some of the PIIGS, but none of these economies are exactly booming.

Update: Doug Irwin tells me that Joan Robinson used to called ideas like a fiscal devaluation “Silly clever”.  I think it is an excellent term – from time to time you will see economic papers that are overly mathematical and complex that come up with answers that are a result of certain (random?) model assumptions that gives anti-economic results. I am afraid silly clever has become fashionable and certain academic economists.

Update 2: My friend David Glasner just wrote a blog post addressing a similar topic – competitive devaluations – we reach very similar conclusions. I love David’s Ralph Hawtrey quote on competitive devaluation – it is very similar to what I argue above.

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