What If Spain Devalued?
December 11, 2014
(This item originally appeared at Forbes.com on December 11,
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
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
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.
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
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
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
.” 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.
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