'Internal devaluation' fails to have desired effect on prices and growth

As people take to the streets to protest at austerity measures, new data on employment and earnings published by the CSO throws light on the effectiveness or otherwise of “internal devaluation” since the economic crash in 2008.

Internal devaluation is a mechanism whereby recession and high unemployment drive down the domestic price level. As prices fall, firms and workers should revise downward both price and wage expectations. The result, so the theory goes, is an increase in economic growth.

There are a variety of channels through which falling prices and wages transmit to economic recovery. One such channel is an improvement in price competitiveness. This can be expected to boost exports and reduce imports.

In contrast, an independent Irish economy could engineer an “external devaluation” by reducing the exchange rate of the Irish pound as was the case in January 1993. However, EMU membership means this is no longer a policy option.

The data published by the CSO covers the four years from 2008 Q2 to 2012 Q2 and covers 13 different economic sectors and 1,496,000 workers.

Over this period, a total of 280,000 jobs were lost. As the theory predicts, the price level did fall by 1.37 per cent.

However, this was not transmitted to earnings as average hourly wages increased by 1.86 per cent. This means that real (inflation adjusted) hourly wages increased by 3.23 per cent.

This is internal revaluation not devaluation. Internal devaluation, it would appear, is not an effective mechanism for moving the Irish economy out of recession.

The apparent failure of falling prices to reduce earnings is critical. Wages are more important than prices as an indicator of competitiveness because the national price level is influenced by indirect taxes and includes many non-traded services and regulated or administered prices.

Surprisingly, it is in the private sector that a decrease in employment is associated with an increase in earnings. Despite an overall loss of 272,000 jobs in largely private sector categories, nominal earnings increased in industry, wholesale, information and the arts.

As expected, there were significant falls in earnings in construction, transport and financial services.

In contrast, and despite the Croke Park agreement, an overall fall in employment is associated with a fall in earnings in the public sector. Approximately 40,000 jobs have been lost in the public sector including semi-state bodies since 2008.

In one public sector, “Human Health”, an increase in employment was associated with a decrease in earnings. In education, there was little change in employment and an increase in earnings.

Workers in both the public and private sectors will point to the negative effect of pension levies and the universal social charge on net pay.

However, revenue generated from these sources is used to finance the government’s budget deficit and does not reduce the labour cost to employers.

Fortuitously, due in large part to a fall in the euro exchange, the Irish economy has experienced an “external devaluation” over the last four years.

The dollar-euro exchange rate fell 18 per cent. The harmonised competitiveness indicator (HCI), derived using the consumer price index and unit labour costs, fell 16 per cent and 26 per cent respectively over the period. These indexes are the most comprehensive measure of price competitiveness in Ireland.

Partly as a result, the current account of the balance of payments has moved from a deficit of 6.6 per cent of GNP to a forecast surplus of 4.3 per cent of GNP in 2013.

Despite the Troika’s fiscal austerity programme, the Central Bank is also forecasting a modest growth rate of 0.7 per cent in 2013. It is a matter of concern, however, that it is external, rather than internal, devaluation that is underlying the fragile recovery.

If the economic gods had decreed otherwise, the euro exchange rate could just as easily have moved in the opposite direction with potentially catastrophic consequences for the economy.

This clearly illustrates the precarious position of the Irish economy in EMU.

* Dr Anthony Leddin is head of the department of economics at the University of Limerick. His new book Macroeconomics: An Irish and European Perspective, co-authored with Brendan Walsh, will be published by Gill and Macmillan early in 2013