What If Spain Devalued?

What If Spain Devalued?

December 11, 2014

(This item originally appeared at Forbes.com on December 11, 2014.)


Whenever a country gets itself into big trouble, a certain cadre of economists insists that all can be made right again if the government would just devalue the currency.

We have been devaluing currencies for so long – hundreds of years – that, if this were true, you’d think we would have noticed by now. I recently looked at the history of all the 150+ currencies of the world since 1950. Almost all of those countries and currencies have an extensive history of devaluation. I don’t think you’ll find single country that managed to devalue itself to prosperity.

Nevertheless, currency devaluation obviously has some attractions, for someone somewhere, or it wouldn’t remain so popular today. Let’s think about devaluation a bit, using Spain as an example.

Let’s say that Spain, now part of the eurozone, somehow issues a New Peseta and that this currency falls from one peseta per euro to two pesetas per euro in a short period of time (a month perhaps), a devaluation of 50%. We will assume that all existing euro commitments, such as bonds or employment contracts, for people and entities in Spain, are declared to be payable in pesetas in a one-to-one basis. The peseta then continues as an independent floating currency, although it is roughly stable around 2 per euro for the time being.

Thus, the principal value of the debt of the government of Spain, in euro terms, falls by 50%. The debt of all other debtors in Spain, such as corporations, banks and households, also falls by 50% in value in euro terms.

At first, this is not such a big benefit for Spanish debtors including the government, because their income, denominated in devalued pesetas, also declines by 50% in euro terms. The government’s tax revenue and debt are devalued together, as are households’ wages and mortgage debt. However, before too long, tax revenue, corporate revenue, and wages begin to rise due to the economy’s inflationary adjustment to the currency devaluation.

Debt default thus becomes less common. Banks’ assets and liabilities are devalued together, but the decline in default rates allows banks, previously struggling with bad debts, to regain some financial health. Overseas assets of banks (such as German government bonds or loans to Italian corporations) double in value in peseta terms, which improves their balance sheets considerably.

As default rates decline, corporate bankruptcies also decline, which means less job losses. Spanish workers, whose salaries have been cut in half in euro terms, are now very “competitive” (i.e., low paid) compared to those in Portugal or Italy. Thus, Spanish export businesses enjoy a boom. Spanish domestic businesses, however, do not enjoy much of an advantage, as workers are not able to buy much with their devalued incomes. Also, the cost of imported goods and services has doubled.

British and German office workers, looking for a midwinter escape or a retirement destination, flock to Spain instead of Greece, to take advantage of all the cheap travel deals and beach-side senior communities.

Thus, Spain enjoys a burst of business and also hiring. The economy seems to improve, and tax revenues begin to rise, at least in nominal peseta terms. The consumer price index rises 20% in the first year after the devaluation, as prices gradually adjust upward. Economists congratulate themselves for “conquering deflation.”

Especially if it begins with beaten-down crisis valuations, the stock market might soar, although it would have to go up 100% just to get even in euro terms.

Isn’t that a happy picture?

But it doesn’t stop there. What about all those French banks that made loans to Spanish corporations? What about all those Spanish government bonds owned by German banks? The loans and bonds are now worth only 50% of their face value in euro terms. French and German banks thus go into state receivership, and millions of French and German depositors are “bailed-in” with huge losses.

Resort destinations in Greece and southern Italy are devoid of customers, and begin defaulting on their debts. Automobile and appliance manufacturers with factories in Germany and Poland can’t compete against cheap Spanish imports, and begin defaulting as well. Unemployment rises.

The Spanish worker has a new job, but his wages, cut in half in euro terms, don’t buy what they used to. Prices rise, and although wages rise also, they don’t keep up. Spanish pensioners are especially hard hit, especially those who depend on savings in Spanish banks. While their counterparts in France and Germany had 30% losses in the “bail-in,” the Spanish savers find that they are able to buy 30% less with their savings and interest income.

The Spanish tax system does not adjust to the devaluation, in part because although parts of it are “inflation-adjusted,” the official inflation numbers are heavily fictionalized by the government. (This also helps “real” GDP look better.) The result is “bracket creep,” whereby income tax brackets intended for higher incomes fall on what is effectively lower and lower incomes. This produces an overall drag on the economy which hardly anyone is able to identify. Instead, blame is laid largely on high imported energy prices.

After a little while, a few years perhaps, Spanish workers’ wages have risen enough that the “competitive advantage” has largely disappeared. Also, competitors in other countries have had to lower their prices to compete. The effective higher taxes are introducing a persistent laggardness to the economy.

In addition, the financial system has become dysfunctional. After the devaluation, nobody is willing to make any more loans in pesetas, because who would want to have their assets devalued again? Domestic interest rates are high, and loan volumes are low. Large corporations are able to borrow in euros, but this is not available to households and small businesses. Households, burned once, do not keep their savings in Spanish banks, but find informal ways to save and invest that do not involve the financial system. More sophisticated households simply use German banks, and their savings and capital never return to Spain.

Thus, the Spanish economy has poor capital creation, a distorted investment environment where all but the largest corporations are unable to raise financing, and thus poor job creation. The economy lags. The government begins to run deficits again, as tax revenues are disappointing and demands for welfare services are high. They cannot issue debt in pesetas except at prohibitive interest rates, so they too must borrow in euros. Even this is difficult, so, to resolve the deficit, the government increases taxes still more.

As these difficulties mount, certain economists believe they have just the solution: devalue again! This chorus is joined by major exporters, who would love to enjoy a further “competitive advantage” of more cheap labor. These export-oriented businesses, as they have benefited economically, have also become more politically influential. Businesses that have been hurt by the devaluation, such as import and domestic businesses, become less politically influential and often simply cease to exist. Thus, the political system contorts toward more devaluation.

What of the remaining eurozone, which now does not include Spain? As bank insolvency mounts, defaults and unemployment rise, and corporations complain about their “competitive disadvantage,” Brussels decides to impose stiff import tariffs with unruly Spain. Before long, Italy and Greece also decide to devalue, and to protect from this “beggar thy neighbor devaluation,” Brussels slaps tariffs on them too. This is the final straw for the French and German banks, which are totally obliterated. In the chaos, the governments of France and Germany halt some debt payments, but are able to catch up and resume their debt servicing schedule before too long. The euro, or what remains of it, is yanked to and fro in the environment of panic and turmoil, but with German discipline (unfortunately combined with high interest rates), disaster is avoided.

After two years of catastrophe, France and Germany also devalue, and have independent floating currencies. The euro is no more. Now that everyone has devalued, their exchange rates are not much different than when they began, as part of the eurozone. There is no more “competitive advantage.” Now employees across the continent have seen the value of their wages cut in half, along with depositors in banks – with German depositors having suffered both the “bail-in” and devaluation combined. The tax system becomes more oppressive across the continent. Capital creation and efficient capital allocation is in disarray everywhere. Unemployment is a persistent and seemingly insoluble problem. Prices rise, and wages do not keep pace.

Unreliable floating currencies dominate the continent, as governments continue to grasp at “easy money” for their endless difficulties. Trade and cross-border finance is crippled everywhere by this new chaos.

Eventually, with the similarities now too numerous to ignore, historians begin calling it a “Second Great Depression.” Fortunately, it is not followed by war. But, just as was the case in 1944 at the Mount Washington Hotel in Bretton Woods, New Hampshire, governments eventually decide that enough is enough. They reinstate a new worldwide gold standard monetary system, which provides the foundation not only for two decades of peace and prosperity, as was the case in the 1950s and 1960s, but two centuries.