Eurozone: The Paradox of Austerity

Includes: ERO, EU, EZU, FXE, IEV, VGK
by: Firat Ünlü

It’s a lovely, sunny day and I finally get to spend some time at home so I’ll keep this piece short. Nonetheless the point I’ll be making is an important one which so far to my knowledge hasn’t been mentioned.

Typically devaluing one’s currency is associated with gaining a competitive advantage, however there are certain peculiarities in the eurozone which make this a bit more complicated. In order for internal/external devaluation to work it is important that the nation in question actually has either a decent industrial policy, an already existing export base or increasing investment into this area.

South Korea benefited from external devaluation after the Asian Crisis because it had companies like Samsung, Germany benefited from internal devaluation in the 2000's because it has a large manufacturing base.

Now that the euro is getting cheaper some sections of the public are in a way euphoric as they sense a chance to outcompete China and make a dent into their dominance. But they forget that the dynamics for Northern Europe and Southern Europe are, again, vastly different.

I will use the example of Greece and argue that through internal devaluation Greece risks becoming uncompetitive as this has repercussions on the euro which erode most of the gains, the conclusion holds true for other countries as well.

The argument is straight-forward, the euro has been under enormous pressure because investors question its safe-haven status, are afraid of sovereign default and ECB monetization.

As Greece is undertaking efforts to increase competitiveness on the world market through cuts in wages and public spending the effect on the euro, ceteris paribus, should be to increase its value. Thus the more success Greece has internally, the more it will face headwinds externally. Reducing the deficit will remove worries over ECB bond purchases and cause the euro to rally.

What’s further is that the FDI situation looks troubling; typically investors tend to a wait for a while before committing to a project as volatility can have negative effects on the investment. How is an investor supposed to make reliable calculations when any gains he might make on wages are offset by a rising currency? The British pound looks unlikely to regain former heights for some to come thus investors and companies have every incentive to boost capacity.

Greece’s export growth will be from price-competitive products but as it suffers from a weak basis it needs to provide cost reliability to counter this uncertainty which it can’t. Thus Greece will be stuck in a situation where it lowers wages but fails to attract sufficient investment.

In conclusion, Southern European nations will face a challenging environment not only because of domestic spending cuts but also because internal devaluation looks unlikely to provide the gains needed for export-led growth.

Disclosure: No positions.

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