Some observations regarding the Internal Devaluations in the EU

I would like to come back to the much discussed issue of internal devaluation. As in every debate there two sides here and each one of them is very much sure of their arguments.

Internal devaluation has more chances to succeed, the bigger the tradable sector (and the more export-oriented it is) of the affected country is and the smaller the country’s dependence on domestic demand. This is based on the fact that internal devaluation (i.e. among others, the slashing of wages to improve competitiveness) adversely affects domestic demand, hence the affected country’s chance of having a “soft” (or “relatively softer” if you prefer) landng is higher the larger its external sector is.

The sample of countries that have enacted an internal devaluation strategy is limited (or maybe the number of those that I’m aware of is) so I don’t know if what I’ve tried to do in this post is statistically proper. The countries that comprise my sample are Estonia, Greece, Ireland, Latvia and Lithuania. I’ve left out Germany since it is a large economy and large economies tend to have lower export ratios (as % of GDP), Hungary because in this case the strategy was halted abruptly and Portugal since they joined the “internal devaluation club” much later than the rest, in the middle of 2011 and a full year has not yet lapsed. Greece entered an agreement with IMF and the EU on May 2010, while Ireland did so on November 2010. The Baltic countries started their internal devaluation adjustments in 2009. Running regressions with 5 observations is without doubt not statistically proper but my intention is just to try to showcase the relationship between the two variables. 

I used average real GDP growth for the years following the initiation of an internal devaluation strategy irrespectively for when IMF/EU programs were terminated (except of course if they were unilaterally terminated like in the case of Hungary) or for the cases where a country initiated such a strategy on its own accord.

My intention is to have a go at showing which fundamental characteristics of an economy may increase the chances of success of the internal devaluation strategy.

There are some inconsistencies in my methodology but these are due to a sheer lack of data. For example, I used the World Bank Ease of Doing Business Index for 2010 and 2011 even though I refer to real GDP growth for the 2009-2011 interval. I had some data for the said index dating back to 2009 but since these cannot be found anymore in the World Bank website I guess that this means that they are no longer valid. I would be grateful, if someone that knows differently said so in the comments section. As a reminder this index is actually a rank so a value closer to 1 means a better ranking. 

To control for the economies’ fundamentals I used Domestic Demand for year 2008 (right before the global recession acquired full force status) and Exports for year 2008. This way I want to highlight the importance of a country’s fundamentals, before they embarked on their respective internal devaluations and before the current depression.

Enough with the intro then, I should let the charts roll in.

As a legend, I should say that the light blue dot is for Estonia, the dark blue dot is for Greece, the green dot is for Ireland, the dark red dot is for Latvia and the yellow dot is for Lithuania.

source: Eurostat, own calculations

As you can see the cumulative decrease in real GDP tends to be smaller in countries where domestic demand accounts for a smaller chunk of GDP.

source: Eurostat, own calculations

It seems to me that indeed, countries with a larger external sector experienced a smallest overall decrease in real GDP from their pre-recession levels.

source: Eurostat, World Bank, own calculations

It seems that there is a positive relationship between the Ease of Doing Business rankings and real GDP growth. 

I next want us to have a look at the interaction between changes in employment after the internal devaluation strategies were initiated and the countries’ rankings in the Ease of Doing Business survey.

source: Eurostat, World Bank, own calculations

The scatter plot shows that there is a positive relationship between the perceived business environment and changes in employment. Now let’s have a look at unemployment.

source: Eurostat, World Bank, own calculations

It seems that changes in unemployment exhibit a negative relationship with the countries’ rankings in the Ease of Doing Business survey (or actually a positive survey if we take rankings literally but since a higher ranking number is negative I think it’s best to say that they exhibit a negative relationship).

Since averages may well hide sizeable divergences among values comprising the samples (if one is so charitable to call what I’ve used here as samples) I would like to finish the post with some charts showing actual values for the figures used in the regressions above.

Here’s real GDP growth.

source: Eurostat

 Here’s employment.

source: Eurostat

And this is unemployment.

source: Eurostat

Here are exports as a % of GDP.

source: Eurostat

And here is Domestic Demand.

source: Eurostat

Finally, here are the World Bank Ease of Doing Business Index rankings.

source: World Bank

Let me wrap this up. Since this is a highly politicized issue I wouldn’t like to make any further comments, I’ll let you draw your own conclusions from the charts. I hope that you’ve got this far and the ridiculous amount of charts didn’t put you off.