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.

Leave a comment


  1. Petar Sisko

     /  February 11, 2013

    wow, I never thought about it this way. Really applies to Croatia too, and the failure is quite visible. btw, I guess you meant to write “their” here “policy as the have “outsourced” there monetary policy “

  2. Benjamin Cole

     /  February 11, 2013

    Excellent blogging, per usual.

    Monetary asphyxiation has become the norm in Western economies.

    The worrisome aspect of it is this: Japan never got out of ZLB.

    Can we expect USA and Europe to do so?

    Stay tuned.

  3. 123

     /  February 11, 2013

    One of these rare cases where I disagree with Lars.

    “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.”
    Gita Gopinath, Emmanuel Farhi and Oleg Itskhoki propose fiscal devaluation as a supplemental tool alongside the easier monetary policy by the ECB, debt restructuring, structural reforms etc. The idea is presented in protectionist terms, but hey, a currency war sounds pretty protectionist too. In any case, the authors want to achieve the same real allocation of resources that would be achieved if PIGS had independent central banks and could do a monetary stimulus. The reason the paper is called “fiscal devaluation” and not a “fiscal cut of interest rates below zero” or a “monetary stimulus by fiscal means” is because the exchange rate is a convenient indicator of a monetary stimulus for small open economies.

    “Maybe it is not a surprise that the French government – … – find a fiscal devaluation attractive.”
    The highest raise in VAT in France was for domestic restaurant services, so VAT increase has no trade distorting effects, so this step by Hollande mimics conventional monetary easing pretty well.

    “The point is that a fiscal devaluation is negative sum game – it hurts everybody”
    The authors present a fiscal devaluation as a solution to those countries that lack monetary policy. The gold standard is irrelevant, as other countries will ease monetary policy in response and euro will appreciate, so fiscal devaluation will fail to improve the competitiveness. The relevant comparison is fiscal devaluation when other countries do the currency war. It is a win-win game. Remember the Sumner critique.

    “The euro crisis is not a competitiveness problem, but a NGDP crisis.”
    Yes, but the eurozone is not an optimal currency are, so there is some role for fiscal devaluations/revaluations.

    ” 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?”
    Authors say fiscal devaluation will not solve the crisis, as a feasible fiscal devaluations would be limited in size. Authors say this idea should be tried as a supplement.

    “India of course pursued (and to a large extent still do) the kind of policies that the fiscal devaluationistists advocate. ”
    Gopinath advocates normal neutral monetary policy for India, she also advocates fiscal austerity and structural reforms.

    “In fact there has been a quite drastic improvement in external balance in some of the PIIGS”
    In fact, fiscal twist could increase the real quantity of money in PIGS, stimulate domestic demand and reduce the extent of current account adjustment that is needed.

  4. felipe

     /  February 11, 2013

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

    I think this is wrong. Governments are here to stay for the foreseeable future, and thus taxes stay too. So it makes sense to try to achieve the required revenue via the most efficient taxes possible. I don’t know if payroll is more efficient than VAT, but you seem to imply that there is no gain to be made by selecting more efficient taxes.

    • Felipe,

      I agree that the tax structure should be as “efficient” as possible. What I object to is the idea that playing around with the tax system in some way can solve this crisis.

      • fsateler

         /  February 12, 2013

        Yes, I agree it is very unlikely to do much good for the current crisis.

  5. Silly clever is indeed a nice way of phrasing/criticizing th idea of fiscal devaluation. And yes you can label it protectionism. On the other hand, how is this different from QE ? QE is steath protectionism as well because it automatically implies a weaker exchange rate or stealth devaluation. So QE or changing the tax rates (higher on imports and subisizing exports) is basically the same. And I am afraid i don’t quite get it why a monetary devaluation through the exchange rate would be a positive sum game

  6. There is an IMF Staff Discussion Note, June 18, 2012, “Fostering Growth in Europe Now” regarding “fiscal devaluation” as I pointed to in my blog in a short entry

  7. Cantillon

     /  February 12, 2013

    I think the author entirely misses the point of the proposal. A currency devaluation is supposed to favour exports and penalise imports by means of a relative shift in costs (which can, of course be moot, if you are a more urgent and less price-sensitive buyer of inputs from abroad – e.g. crude – than you are a seller or processed wares- and many export industries, especially in the developing world tend to be cut-throat price takers, in any case).

    Adding to the supposed gains, local currency wage rates become cheapened compared to one’s competitors abroad without reducing their nominal amount. The exporters, ipso facto, can employ more labour (lowered costs, stable selling prices), as can import substituters (stable costs, increased selling prices.

    The ‘fiscal devaluation’ route does not attempt a crude protectionist copy of this, contrary to what has been argued above, since the idea is to raise VAT on ALL consumables – whether these originate at home or abroad – and to use the tax monies to lower labour costs to the employer WITHOUT altering wage rates (albeit by seeing to it that those same money wages command fewer goods).

    The first measure penalises an exhaustive consumption which in current account deficit nations has clearly been running too high and hence contributing to unproductive indebtedness: it therefore favours saving and hence the productive investment which the stricken country needs in order to restore its real standard of living (sorry, Cargo Cult, Keynesian underconsumptionists).

    The second part of the switch raises marginal returns to labour (the employers’ overall bill is reduced) which, taken with the additional capital means hopefully generated by the earners’ consumption/investment shift (and here we might add that a back up tax advantage on returns to capital/savings to magnify this shift would also therefore be beneficial), should increase employment and output and eventually raise real standards of living beyond those prevailing before the VAT rise.

    Of course, it would be even better if the state just slashed payroll and capital taxes and cut back meaningfully on its bloated outlays, but, on step at a time, chaps!

  8. Cantillon

     /  February 12, 2013

    Apologies: Para II above shuld have read:-

    Adding to the supposed gains, local currency wage rates become cheapened compared to one’s competitors abroad without reducing their nominal amount. Money illusion reigns. The exporters, ipso facto, can employ more labour (lowered foreign currency costs, stable foreign selling prices), as can import substituters (stable domestic costs, increased domestic selling prices), ceteris conveniently remaining paribus

  9. This is a very important discussion on the forms of external adjustment, which is nearly taboo in Eurozone. Unfortunately, this interesting analyis needs to be much more empirical, and to distinguish between the types of countries, big, small, net exportors or net importers, etc.

    What is the best way to achieve Balance of Payments adjustments in the context of a fixed conversion rate?
    A traditional monetary devaluation is bilateral, as it alters the relative X/M prices in both the net importing and the net exporting countries. If the importer can control its own monetary policy and is financed in its own currency, it can even inflate away some of its real external debt (ex. US, UK). Most of the X-M adjustment is achieved through the price-elasticity rather than income-elasticity.

    A “fical devaluation” is unilateral, it affects mostly the net importing country, and it operated primarily through the mechanism of income-elasticity, reducing the demand for imports by reducing local disposable.
    This is not just from the textbooks, this is what is happening in Portugal circa 2012.

    In the Eurozone, the small net importing countries a one-armed midgets, all they have left is fiscal and incomes policies, which they use and abuse. They can’t alter the X/M price relationship, they can’t, use monetary policy to adjust the price and supply of credit to the local economy, they don’t have the economies of scale to compete in the increasingly polarized export markets, they can’t re-orient credit to export-oriented sectors, and they certainly can’t force the net-exporters and net-creditors to share the losses for the excessive credit they made to recycle their export surpluses.

    Who ever heard of “unilateral” external adjustments?
    To evaluate how badly these unilateral devaluations are working to rebalance trade within and outside of the Eurozone, just look at the record German trade surplus of 2012. See more in the blog PPP Lusofonia

  10. Lars,
    Your conclusions are a bit hasty–many of the points that Castillon made just above which are robust. Also, you have to be careful not to windowdress incorrect assumptions and conclusions in high street econospeak. Wrong is wrong: Your statements about this being an issue of demand rather than competitiveness is simply incorrect; the crux of the whole problem in Europe is that there’s far more demand in southern Europe than there is real income to fund it. Otherwise known as an overhang, when purchasing (eg demand) gets way ahead of productivity. Among other sources, Jazz Me provided the IMF paper that verifies this. Monetary devaluations usually keep populations from importing expensive finished goods from richer economies by effectively creating inflation (eg the number of currency units in the poorer country goes way up, making that iPhone or Mercedes much more expensive in local terms), but the single currency prohibits that. Hence the floodgates have been open for 12 years and a massive gusher of German goods has been flowing south.

    It is widely known and accepted that giving southern Europe purchasing parity to Germany by way of the single currency essentially has meant that southern Europeans have been able to afford buying more German goods than they were before the Euro, hence the tremendous export growth and economic success Germany has enjoyed (115% growth actually, from 1998-2011 according to Eurostat).

    Internal bank transfers from the Bundesbank through the ECB show that this export success Germany has been enjoying is not without its darker ramifications: Germany is largely financing the newfound purchasing power in the south (eg the gap in real productivity, also spoken of in terms of competitiveness) because the south’s productivity has not been able to keep up with the demand for goods available via purchase facilitated by the single currency. The ECB-Bundesbank clearing system for cross-border capital movements, is called Target2.

    Hans-Werner Sinn of Germany’s Ifo institute has published a book on the dangers of this system. The Guardian newspaper published an article in January elucidating it. Here’s an excerpt:

    Hans-Werner Sinn of the Ifo-Institute has shown [that the key explanation], lies in the deceptively innocuously named European Central Bank’s inter-banking payments settlement system for cross-border trade, services and capital transfers within the eurozone, known as Target2. Every time money flows from the banks of one euro member country to the banks of another, it does so through the Target system (unless, of course, the money flows across the border as cash in a suitcase).

    The basic mechanism of this system is simple enough: let’s assume a Spanish company orders 50 state-of-the-art diesel engines from a German manufacturer. Once the German exporter has delivered the engines, the Spanish importer will advise his bank to transfer the agreed purchase price. The Spanish bank will initiate the transfer through the Spanish central bank, which will credit, ie enter a liability on its accounts in favour of, the German Bundesbank, which in turn credits the sum to the bank of the German exporter. The Spanish importer gets his machines, the German exporter receives his money, but – and here’s the twist – the money never leaves Spain and it never enters Germany. Instead, the Bundesbank receives a Target2 claim against the Bank of Spain.

    On 30 November 2012 the Target2 claims by the Bundesbank against other eurozone central banks stood at €715bn (£581bn).Through its Target2 credits, the Bundesbank is financing German export and current account surpluses within the eurozone because southern Europe has never had the money to import German goods on such a scale. The Bundesbank’s Target2 credits amount to about two thirds of its entire balance sheet. They are entirely unsecured.

    Many commentators, including the Bundesbank, have countered that these are merely accounting numbers in a settlement system. Within the eurozone, it all balances out to zero. No need to lose sleep over it. This is, to say the least, disingenuous. Let’s assume you lend £100 to your brother, who is having “balance of payments” difficulties. Within the family we have +£100 for one of the members, and -£100 for another. Nets out to zero within the family. But that does not make you sleep any better. What if your brother cannot surmount his balance of payments difficulties and simply defaults on paying you back?

    Germany’s total exports in 2011 were €1.06 tn. Of those, around 37% went to the eurozone. From November 2011 to November 2012 alone the Bundesbank’s Target2 claims rose by around €220bn. This means that in recent years, well over half of Germany’s total eurozone exports have been financed by the Bundesbank, which is broadly equivalent to Germany’s current account surplus with the eurozone. Its Target2 “loans” ensure German industry gets its money. For €220bn the Bundesbank could have financed the sale of 11m VW Golf cars to the German population. For the total €715bn “lent” to the eurozone so far, the Bundesbank could have almost re-equipped the entire German passenger vehicle market of 43m cars with new VW Golfs free of charge.

    If the Bundesbank had printed and invested the money at home, it could have stimulated domestic demand, or reduced German public indebtedness to well under the 60% of GDP required by the Maastricht treaty. The Target2 system instead forces the Bundesbank to act as a supremely inefficient German sovereign wealth fund which is allowed to invest in one type of asset only: public and private southern eurozone debt. This German “wealth destruction” fund allows the euro countries to buy German goods they cannot afford and provides German industry with a multibillion euro export subsidy, which it does not need.

    (full article here: )

    The point: If European politicians insist on preserving the Euro, as they have and continue to do, then there MUST be an alternative mechanism introduced that can allow for comparative differentials in the productivity of labor (eg competitiveness) to dynamically and regularly adjust so that regional economic areas can continue to trade– because Germany can’t finance the gap indefinitely.

    On this basis then the Fiscal Devaluation offers an interesting ancillary toolset and concept direction worth exploring, because it does allow a country to unilaterally achieve an adjustment similar enough to an exchange rate adjustment that it can relieve pressure and increase the return on labor expense, which is a synthetic way of increasing the (cost) competitiveness of Labor. It won’t work forever, but it’s a quick mechanical option that will buy hurting economies time to make more significant structural changes they must make (but which require much more time to implement) to remain relevant over the longer term– this is likely what Gopinath and the other authors intended and meant.

  11. Gavin R. Putland

     /  September 4, 2013

    I have become a proponent of so-called “fiscal devaluation”, not as a means of emulating currency devaluation or protection, but as a means of removing a “tax wedge that lowers employment”. In my version of the policy, that “tax wedge” includes not only payroll tax but also pay-as-you-go “personal” income tax, which is paid by employers but credited to employees. (See “Fiscal devaluation on steroids” – – for details).

    Eliminating the “tax wedge that lowers employment” is the end. Raising the VAT is only a means of replacing some of the revenue (SOME, not all, because lower unemployment means less expenditure on welfare).

    Yes, an inland VAT captures the value added to imports but excludes the value added to exports. And inland taxes on labour capture the labour content of exports but exclude the labour content of imports. So if a VAT is protectionist, a tax on labour is reverse-protectionist! Shall we condemn protectionism but condone reverse-protectionism?

    Moreover, the advantage of VAT over labour taxes is not limited to the exclusion of exports. For example, VAT, unlike taxes on labour, excludes value added in capital formation. Consequently, substituting VAT for taxes on labour leads to more capital formation, hence faster growth, hence (later) greater capacity to consume.

    Untaxing the labour expended in capital formation is not “twisted”. It is not protectionism. It is not a subsidy for exports. It does not assume that exports are somehow better than domestic demand. It is not a negative-sum game. It is not even a zero-sum game.

    (Note: In “Fiscal devaluation on steroids”, I describe currency devaluation as a zero-sum game because I consider only the value of the currency, not the means by which that value might be lowered).

    If the real problem in the south of the eurozone were “lack of aggregate demand”, then securing people’s jobs by means of “fiscal devaluation” would be one way to restore the necessary demand.

    The criticisms directed at the modern form of “fiscal devaluation” – lowering taxes on labour and raising VAT – are more applicable to the older form: subsidizing exports and taxing imports. The older form is not aimed at any “tax wedge that lowers employment”. The older form is indeed a negative-sum game because it distorts the pursuit of comparative advantage. The older form is indeed protectionist. But, whereas the older form moves the tax burden from exports to imports, the modern form moves the tax burden from production to consumption.

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