On June 7th and 8th the heads of state and governments of the seven most important industrialised countries will meet at Schloss Elmau in Germany to consider, among other important topics, how to increase economic growth and employment.
The challenges faced by G7 states, in particular European ones, are legion:
- Boosting production and employment by increasing public debt is no longer possible because sovereign debt has already reached levels that are unsustainable in the long run.
- Expansive monetary policy is also reaching its limits, with central bank’s interest rates in most advanced industrialized nations already close to zero. The permanent increase in money supply raises the specter of inflation and speculative bubbles.
- The devaluation of the domestic currency in any one country, intended to increase exports, may cause devaluations in the rest of the world. This may lead to a global currency war. Furthermore, countries that are a member of a currency union such as the euro are unable to devalue their currency.
So, given these restrictions, how can advanced industrialized nations increase production and employment? One tool that can be used to boost economic growth without increasing government debt or expanding the money supply and without devaluing the domestic currency is fiscal devaluation.
Fiscal Devaluation is the reduction of labor costs – usually social security contributions – in order to make domestic products more competitive while avoiding an increase in public debt, by an increase in the value added tax (VAT) rate.
On the labor market, the decline in the price of labor, i.e. in the gross wage, leads to stronger demand for labor and the volume of employment increases. Lowered social security contributions, cause the net wage to go up, increasing disposable income and thus purchasing power.
Elegantly simple, the higher level of employment usually results in higher production. But to prevent an excess supply of goods, demand for goods must rise, too. There are essentially three ways for this to happen:
- Decreasing labor costs mean decreasing production costs and therefore also a decline in the price of goods. As a result, domestically produced goods and services can be offered at lower prices abroad. As consumers abroad are charged their VAT rate, the increase in domestic VAT is irrelevant to them. The home country’s exports increase as a result.
- Since the rise in employment coincides with a rise in the net wage, domestic purchasing power and therefore domestic demand for goods also increases.
- The cut in social security contributions reduces costs of production. Companies can offer any given quantity of a good at a lower price. Taken by itself, the reduction in prices leads to an increase in the demand for goods.
At the same time, however, it is important to bear in mind that the increase in domestic VAT makes consumer goods more expensive and therefore reduces domestic demand for goods.
Overall, fiscal devaluation has two demand-boosting effects (an increase in income and a reduction in prices due to the cut in social security contributions) and one demand-reducing effect (an increase in prices due to the rise in the VAT rate) on the domestic goods market. From a theoretical perspective, it is uncertain which effects will predominate overall. If, however, employment growth is high and the price reductions resulting from the lower social security contributions are large, domestic demand for goods will increase. And even if the demand-reducing effect of the higher VAT rate predominates and domestic demand for goods declines, this fall in demand may be offset by higher exports.
However, the success of fiscal devaluation depends on the reactions of the rest of the world. If, for example, a country’s main trading partners also apply this strategy, fiscal devaluation is less successful or even achieves nothing at all, as the improvement in international competitiveness sought through fiscal devaluation is canceled out by the economic policy responses abroad.
An internationally coordinated approach is required if fiscal devaluation is to have the expected positive economic effects. Coordinated in the sense that only deficit countries should apply this strategy and not countries with high current account surpluses such as Germany and Japan (see figure 2). Therefore, we need internationally coordinated economic policy. The G7 and G20 are ideal institutions for coordinating economic policy. We hope this scenario is discussed or at least raised in Bavaria later this week.