The Nixon option

(I will spell things out a bit more in this post than I might have if we didn’t have an infusion of NYT readers, but probably I should anyway. Some of our readers don’t know a lot about economics.)

We’ve been debating the wisdom of savage wage cuts in Spain and other countries, which Ed thinks is necessary. The idea is that wages have risen far more than is reasonable because of bubbles, which means they’ve become uncompetitive. Normally, that could be solved by currency devaluation, but Spain is in the euro. So Ed wants “internal devaluation”: wages cuts, which will also lead to cuts in prices.

The thing is, what we’re calling internal devaluation isn’t actually analogous to actual devaluation. It’s not even close. It’s not a question of your perspective; it’s not “only” a psychological difference. So how would you get an “internal devaluation” that lived up to its name? Richard Nixon might have an idea…

Currency devaluation can be relatively painless, but wage cuts will be a very painful process. People will be poorer, which will also lead to a collapse in demand, which will lead to a general economic collapse. Price cuts – deflation, sound nice, but are very destructive. It leads to people expecting lower prices, and delaying purchases, which lead to lower production, which leads to lower wages and lower demand, which in turn leads to even lower prices, which leads to people delaying purchases even more. A downward spiral of misery.

Also unlike an actual devaluation, lpeople will have less money to pay back loans, which isn’t a small thing. You already have a lot of people underwater or close in Spain.

History shows that wage cuts and deflation will normally be a very slow and painful process. A government can induce a faster “internal devaluation” by slashing wages for public sector workers. That would still not be very similar to actual devaluation. It would give the economy a body blow, a veritable death blow. Deflation would still be gradual and destructive. It would also hit some people far harder than others, without necessarily targeting less productive sectors of the economy. The more well-off segments of private sector workers probably wouldn’t see any wage cuts at all.

This won’t do. So if – if – savage wage cuts are the least bad option, why not just have a government directive to cut wages for every resident and all prices in one fell swoop, and then retain controls for a couple of months? This way you won’t get a deflationary spiral, you won’t get the same utter collapse in demand. There would be a collapse in corporate profitability, which would happen anyway. It would also be less manifestly unfair.

This still leaves you with loans that haven’t gone down. One immediate thing you could do would be to institute (temporarily) very lenient bankruptcy laws. Currently, they don’t allow any kind of personal bankruptcy, you just (fail to) pay off your debts until you die, and live like a pauper. Probably something more radical is needed.

Most of the arguments against a conventional use of wage and price controls don’t apply here. In any case, Spain doesn’t actually have any good options. What we need to figure out is the least bad option.

Does anyone know if there are any EU rules against something like this?

18 thoughts on “The Nixon option

  1. Under EU law, wage controls would probably not be impossible. I think price controls would be far more problematic both as a legal and practical matter. A Spanish decree imposing (say) a mandatory 20 percent price cut on all goods and services in Spain might be challenged on internal market grounds.

    Anyway, there is nothing to stop multinational firms from simply ceasing to supply goods and services in Spain at goverment-imposed Spanish prices. Suppliers could refer customers to the Internet to buy from France at French prices. The Spanish government could do nothing to stop that without cutting Spain off from the internal market, i.e. practically withdrawing from the EU unilaterally.

    On ‘very lenient bankruptcy laws’ I see a similar problem. Presumably this would push more problems onto Spanish banks, who would face increased loan volumes going bad. Capital then start to stream from Spain to safer EU countries, putting more pressure on the Spanish banking system. The only way to stop it is Spanish capital controls, contravening EU law…

  2. It’s interesting that when I saw the title of this post, I was thinking a little parochially and thought it referred to another aspect of the Nixon shock, the 10 percent import surcharge.

    With Europe, Japan, China and the rest of East Asia taking the beggar-thy-neighbor tact, it might be an appealing course for the U.S. It certainly would be popular here… 😉

  3. In a democracy, the only legal tools a government has for fiscal control are taxes and spending (cuts or increases). Your idea will be against fundamental laws, basically you are planning to confiscate peoples property in a way that suits an ideology. In the EU context it is impossible legally. Devaluation of the euro is happening now, and it can be manipulated by common agreement. Country specific measures with drachmas or pesetas etc.(all of which basically try to confiscate savings) can always be circumvented as long as the government respects the EU law.
    If Greece or Spain leave the EU and euro and go to a dictatorship, the situation will not improve much, see what happens in Venezuela:
    As a matter of principle, there exist no measures that can be effectively taken other than cutting spending and increasing taxes. Of course trying to restart the economy and help the weaker etc. are required but will not help at the immediate problem.

  4. I think there is an alternative. Look to the Nordics, there has been quite some writing on the effect of centralized wage bargaining, nordic style, on competitiveness.

    If, say, politicians and business leaders started to lead by example, they could start by cutting their own wages – I guess competitiveness could be restored in a few years, with far less pain.

    I think Karl Ove Moene had an excellent article on this in a Development Outreach from the WB some years ago, but I can’t find it back. Sorry for that.

  5. To reduce wages should be possible legally.
    To reduce prices can be achieved by removing VAT or other price related taxes. The reduction in government revenue from these taxes would be partly balanced by reductions in public sector pay. To reduce the debt burden of individuals so as to accomodate lower income it may be possible legally to oblige banks to restructure private and commercial debt to longer term or lower interest. This could be in conjunction with ECB cooperation in the form of guaranteed longer term low interest lending to the financial institutions that were obliged to follow such a plan – such terms by the ECB would have to be offered equally throughout the Eurozone. Much to study as to feasibility of ECB involvement.

  6. Not everybody is a wage-earner, so you cannot possible be evenhanded. Devaluation is a falling tide that lowers all boats; cuts are not.

  7. Except when the boats are all sunken or propped up on dry land for repair, and if there is no real tide in these protected waters then better fix the boats so that they sit properly as we cannot wait for the tide to go down to try to refloat them once they have sunk.

  8. Spain’s net external debt is 93.5% of GDP. I do not know whether that looks small to you, but increasing it by 20% is unlikely to help.

    The crucial question is: has an internal devaluation ever worked anywhere in the world? No. So, as we say in Spain, “los experimentos, en casa, y con gaseosa”.

    We Spaniards greatly appreciate your attempts to look for the least bad option. But I think we should all face reality. The only tried and proved way out of the current situation in Spain is

    a) Establish a corralito to prevent a run on the banks (which is already under way)

    b) Leave the euro and devalue

    c) Restructure the debt, including a internal conversion of debt from euros to neopesetas.

    d)Apply strict reforms, but with the wind of strong economic growth at our back and in the aftermath of a terrible shock to national self-esteem which will disarm any opponents of change.

    That is the only route which reduces the pain for the average Spaniard, lowers the burden of debt, both private and public, to manageable levels, gives an adrenaline boost to Spain’s exporting sector, and ensures that you can reform the economic and political system.

    And who gets punished if we default? The big banks. Oh, poor them…

    Thus, we would like to ask you smart analysts to focus your minds on charting the technical path to devaluation. How can this be accomplished in an ordered way? How do you actually convert euro deposits and debts to pesetas and change the circulating coins and notes? How do we avoid an Argentinian chaos?

    That would be useful stuff.

  9. Why not take tax off labour and switch to land value/monopoly tax. This way you get an immediate cut in wages but take home pay stays much the same and it gives the banks the incentive they need to start moving real estate property off their books. House prices will drop reducing carrying costs for workers and makes Spain more competitive. What´s not to like?

  10. The debt is the problem. To leave the euro would impose a ‘simple’ broad devaluation to which all else would have to adjust. The foreign debt is owned through Spanish banks largely to northern EU banks – this works both ways where their weight is applied to ECB and Eurozone policy to help support their investments and hence maintain Spanish funding and valuation. This comes at a cost – instead of banks failing or the currency devaluing to support them society endebts itself further to support banks as they supposedly wind down. Ultimately the choices on debt are few – restructure, default , write down or ‘reinflate’ through currency devaluation attracting further investment or enabling local monetary expansion. The latter two won’t nescessarily work well now for several reasons – from global demand of safer investment, to the foreign debt still being foreign debt which will unlikely be rewritten at a fixed parity (i.e. you would still have to buy euros to repay it, so print one peseta to a euro and all else being equal you pay a peseta for a euro’s debt, print two and you pay two. If the peseta then sinks you owe more, you could then print/borrow more but you would effectively be turning private debt into public debt through further devaluation and borrowing. If the economy for some reason improves (where is the structural change ?) and after such loss of confidence it might bring, then maybe you win. Debt obligations and continued overvaluations are the problem – who to make pay , the lender or the borrower ? For now the government (public) is making up a minimum to banks for the borrowers who don’t pay. You only have to look at the US to see what happens when private debt (particularly mortgages) become unsuportable, something which hasn’t kicked in fully here maybe. No, there is no easy solution to this mess, at all. Write downs and bank failures will only devalue the euro a part of what it would a smaller local currency, and would not remove lack of competitivity within Europe either, though it would mark equity to market and make it cheaper (plus place a lot of borrowers heavily underwater) . Structural changes, reduced government spending hence lower taxes and cheaper prices, a flexible hiring environment allowing faster and cheaper wage adjustments etc. would move to increased productivity however. I don’t think there is a smooth way to leave the Euro or to write down large amounts of debt etc. – I suppose remain humble to the demands of those you owe to so that they will continue doing business with you in the future, unless you plan for a shunned or isolated country ? Spain has had it easy recently, that does not mean it has to take it badly to find itself slightly poorer again, to have to compete, or to have to return to more difficult earnings – it does have to facilitate that transfer fairly however, across all spectrum of society, that can be just as ‘nationalistic’ as reclaiming control of its currency , if not more so.

  11. The UK had a prices and incomes policy in the late 70s, in the EEC as was, so it can be done under the Rome Treaty.

    Btw, suppliers might try to route people to France, but they’d be fools to accept that deal:-)

  12. I see two ways of inducing, accelerating internal devaluation, this or just cutting wages in the public sector, and hope the rest follows.

    A lot of good points made, but I don’t see any arguments why my idea wouldn’t work better than that option, which is really all I’m arguing here.

  13. Third option is to do it over a decade with public wage freezes and general austerity. Again, isn’t my idea the least bad?

  14. If Spain can afford that – government revenue is well down. It is also a burden on the rest of the economy ( its expenses should be justified – what criteria , social or economic ? ), more so if taxes are raised, if taxing the rich it also brings capital flight. Any borrowing to make up the accounts also has to be repaid , with interest, by future workers.

    If it can afford that and if that does not stiffle renewed activity which may happen with a faster adjustment, the latter depends of how people wish the country to be I suppose – slow and stable or dynamic and efficient for example.

  15. “In any case, Spain doesn’t actually have any good options. What we need to figure out is the least bad option.”

    A good option would be to leave the Euro and regain currency sovereignty. The subsequent (market) currency devaluation wouldn’t do much harm to the domestic economy, but it would help exporters and net tourism (fewer Spaniards traveling abroad, more foreign visits to take advantage of cheaper prices).

  16. please proof first that (1) Spain is uncompatitive (high import based upon debt is not proof, otherwise the USA is the most uncompetetive country in the world) and (2) wage cuts would make any difference

  17. I think uncompetitive refers to the manufacturing sector here which is relatively small, most likely due to it being uncompetitive to set up and run here ? Prices in Spain are not competitive any longer compared with the rest of Europe either, they are now similar – seeing as we rely on foreign spending here to support the economy (we cannot endebt further really, nor can the US indefinitely) and that part of the reason the Spanish economy has failed so much is because the economies which spend here have slowed (the other main reason being investment through real estate consruction ending – partly due to the above also which was caused by lending/debt bubbles), to attract further spending here we would have to decrease prices , wage cuts are one way of doing so (as well as encourageing manufacturing investment here too), lowering commercial rents would be another, reducing taxes, producing goods locally might do too. Put simply money will be spread more thinly for quite a while (monetary deflation – ECB liquidity finished with the banks and markets , it has not effectively worked its way into the base economy. Public spending/borrowing will now reduce some of its input too) and consequently business has to adjust to that by reducing costs, or close – that is not even to increase competivity necessarily, but just to stay afloat.

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