Question

Explain in detail why an internal devaluation policy causes a decrease in technological innovation if wages become too low.

Answer 1

Definition of Internal devaluation

Devaluation is often part of the remedy for a country in financial trouble. Devaluation boosts the competitiveness of a country’s exports and curtails imports by making them more costly. Together, the higher exports and the reduced imports generate some of the financial resources needed to help the country get out of trouble.

For countries that belong to—and want to stay in—a currency union, however, devaluation is not an option. This was the situation facing several euro area economies at the onset of the global financial crisis: capital had been flowing into these countries before the crisis but much of it fled when the crisis hit.

A remedy for these economies that has generated a lot of debate is so-called internal devaluation. This is a boost to competitiveness not through an (external) devaluation of the currency but by internal means, such as wage cuts or wage moderation.

ADVANTAGES AND DISADVANTGES OF DEVALUATION

Devaluation is the decision to reduce the value of a currency in a fixed exchange rate. A devaluation means that the value of the currency falls. Domestic residents will find imports and foreign travel more expensive. However domestic exports will benefit from their exports becoming cheaper.

ADVANTAGES OF DEVALUATION

Exports become cheaper and more competitive to foreign buyers. Therefore, this provides a boost for domestic demand and could lead to job creation in the export sector.

A higher level of exports should lead to an improvement in the current account deficit. This is important if the country has a large current account deficit due to a lack of competitiveness.

Higher exports and aggregate demand (AD) can lead to higher rates of economic growth.

Devaluation is a less damaging way to restore competitiveness than ‘internal devaluation‘. Internal devaluation relies on deflationary policies to reduce prices by reducing aggregate demand. Devaluation can restore competitiveness without reducing aggregate demand.

With a decision to devalue the currency, the Central Bank can cut interest rates as it no longer needs to ‘prop up’ the currency with high interest rates.

Disadvantages of Devaluation

1. Inflation. Devaluation is likely to cause inflation because:

Imports will be more expensive (any imported good or raw material will increase in price)

Aggregate Demand (AD) increases – causing demand pull inflation.

Firms/exporters have less incentive to cut costs because they can rely on the devaluation to improve competitiveness. The concern is in the long-term devaluation may lead to lower productivity because of the decline in incentives.

2. Reduces the purchasing power of citizens abroad. e.g. it is more expensive to go on holiday abroad.

3. Reduced real wages. In a period of low wage growth, a devaluation which causes rising import prices will make many consumers feel worse off. This was an issue in the UK during the period 2007-2018.

4. A large and rapid devaluation may scare off international investors. It makes investors less willing to hold government debt because the devaluation is effectively reducing the real value of their holdings. In some cases, rapid devaluation can trigger Capital flight.

5. If consumers have debts, e.g. mortgages in foreign currency – after a devaluation, they will see a sharp rise in the cost of their debt repayments. This occurred in Hungary when many had taken out a mortgage in foreign currency and after the devaluation it became very expensive to pay off Euro denominated mortgages.

THE IMPACT OF THE INTERNAL DEVALUATION ON ECONOMY

The first constraint is often referred to in the literature as achieving internal balance, while the second as achieving external balance. The conceptualization of this theoretical framework is the result of work by John Williamson (1985, 1993, 2009) who in 1983 developed the concept of the Fundamental Equilibrium Exchange Rate (FEER) to describe the situation where the real exchange rate corresponds to some natural level of production and a sustainable current account deficit or surplus.

According to Jan Hansen and Warner Roeger (2000) and Rebecca Driver and Peter
Westaway (2004), the equilibrium exchange rate envisaged by Williamson is that which corresponds to the so-called NAIRU (Non-Accelerating Inflation Rate of Un-employment) point that can be established under the open economy theoretical analysis.

Extensive literature in mainstream economic theory strongly suggests that the combination of high levels of production (or low unemployment) and stable inflation requires substantial reforms in the labour market, most of which are directly linked to the economic underpinnings of internal devaluation. Such reforms relate to the minimum wage, the legislative and institutional framework within which workers’rights are enshrined, the collective bargaining framework, the amount and duration of unemployment benefits, the working time etc. According to the advocates of this mainstream approach, the required labour market structural reforms will ensure that downward pressure is exerted on wages, thus increasing the ability of the econ- omy to achieve the desired level of production consistent with stable inflation. In other words, structural changes are supposed to enhance the efficacy of the adjust- ment of the economy through the channel of price competitiveness. However, this internal devaluation approach to adjustment fails to appreciate the significance of the structural competitiveness permeating the extant production systems as well as the main characteristics of contemporary markets.

Nicholas Kaldor (1978) was amongst the first to stress the importance of structural factors in determining the competitiveness of a country’s performance in international competition highlighting, for example, product quality, technological innovation as well as the geographical orientation of exports affecting the income and price elasticities of demand for imports and exports. In the same line of argument, Michel Aglietta (1997) argues that through industrial policy a country will be able to introduce technological innovations in production and, hence, increase its performance in foreign trade alongside institutional changes that encourage invest-ment in new technologies. Furthermore, structural competitiveness depends on many other factors that revolve around qualitative aspects. Some of these aspects include: sectoral specialization and expertise in international trade; the composition and structure of the firms; the quality of labour relations; the social relationships formed within workplaces and the impact they have on the formation of collective forms of work organization; the key characteristics of the domestic market; the rate at which mechanical equipment is replaced; the types of products in which the country has comparative advantage; the reputation of products and many others (Aglietta 1997).
Despite the differences in the internal devaluation and structural adjustment approaches, it is envisaged that it is possible for the existing schools of thought to arrive at a consensus by developing a common framework of analysis.

However,while the formulation of appropriate mathematical models is feasible, the transforma- tion of the equations embedded within the models so that they take into account the theoretical priorities to which each of the conceptual frameworks attach greater importance is a more daunting challenge.