Eurozone: How large is the need for external adjustment?

In addition to the need for government consolidation, the second major challenge facing a number of EMU countries is the reduction of external deficits. Some empirical analyses have reached the conclusion that countries like Spain, Greece and Portugal would have to achieve devaluation of anywhere in the region of between 20% and over 30% to arrive at a sustainable external position.

Within a monetary union, however, an individual country does not have the power to adjust the external value of the currency. The only option is internal devaluation. Internal devaluation means nothing other than cutting domestic costs in relation to the costs in partner countries. Essentially, cutting wage costs is likely to be the only way of achieving this, which is why many doubt whether internal devaluation of any more than 10% is feasible.

What is striking, however, is that some countries, like Spain for example, have already been able to slash their current account deficits considerably, although only a few percentage points have been knocked off unit labor costs. A balanced current account should normally also pave the way for the medium-term consolidation of net international investment positions. So are the estimates produced by the empirical analyses wrong when they point towards the need for substantial devaluation? In some respects, it would appear so.

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