And what about Germany's 'synthetic' competitive devaluation strategy ?

This weekend’s Group of 20 meeting of finance ministers and central bankers in Moscow focused on the prevailing market fears of currency wars and a 1930’s style death spiral of competitive currency devaluations. Following the aggressive push for easier monetary policy by Japan’s new prime minister Shinzo Abe and the resulting slump in the Yen, the Group of Seven felt the need to sooth markets already before the G-20 meeting with the following statement:  

“We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates.” 
(G-7 statement of February 12, 2013) 

Oh really ? While Jens Weidmann, president of Germany’s central bank, vehemently refutes the intention to devalue the euro (“the exchange rate of the euro is broadly in line with fundamentals” .....“you cannot really say that the euro is seriously overvalued”), at the same time he supports Merkel's synthetic competitive devaluation strategy in Europe, i.e. economic austerity policies that synthetically replicate a currency devaluation by changing the value of economic variables, with similar effects on the price of tradables (exports and imports) and export performance. 

Let me expain what I mean by 'synthetic' competitive devaluation:

Just as financial instruments can synthetically replicate risk exposures and generate similar returns as other financial instruments without the need for real assets [1], economic policies can be designed in such a way as to attain the same effect as a competitive currency devaluation without the need to change nominal currency values. For example, a combination of higher value added taxes (VAT) on consumer goods and a cut in payroll taxes or a payroll tax subsidy lowers unit labor costs and lowers export prices as export goods are exempt from VAT. This fiscal devaluation approach has recently been advocated by Harvard economist Gita Gopinath and colleagues as a response to the loss of competitiveness in the eurozone (see Gopinath et al., 2011: "Fiscal Devaluations") and is now being planned in France to revive the country's competitive edge. Keeping nominal exchange rates unchanged, the recommended combination of policies acts as an effective export subsidy and thus leads to the same outcomes as a nominal currency devaluation, namely an increase in exports. 

Germany's Merkel government has pioneered this synthetic currency devaluation approach already in 2007, combining an increase in VAT from 16% to 19% with a cut in employers' social security contributions from 6.5% to 4.2%. The fact that employees did not benefit from a similar cut in social security contributions clearly shows that it was meant to be a payroll tax subsidy for employers designed to lower unit labor costs, the standard measure of competitiveness [2], and thus increase exports. 

The fiscal devaluation in Germany was implemented in addition to the policy measures of Agenda 2010 which lowered nominal wages and non-wage labor costs and put pressure on general wage levels through various labor market liberalization and flexibilization measures. Using Germany's Agenda 2010 as a blueprint, the labor reforms imposed on Greece and other highly indebted countries in the Southern European periphery by Germany's Merkel government and the troika of IMF, EU commission and ECB encompass a number of measures designed (to lower unit labor costs [2] and increase competitiveness:

• the lowering of nominal wages and social security contributions;
• the reduction of unemployment payments;
• the shortening of the eligibility period for unemployment payments;
• the downward adjustment of public pensions;
• the reduction or elimination of labor market regulations, facilitating 'hire and fire'.

The combination of Agenda 2010 and fiscal devaluation policies were so successful that Germany went from a trade deficit in the early 1990s (as a result of the economic boom following reunification with the former DDR) to the global export championship in nearly every year since 2000.

Germany's synthetic competitive devaluation approach, of course, also resulted in huge trade imbalances within the eurozone, injecting centrifugal forces so strong that they risk destroying the European monetary union. This risk is not yet banished but growing as long as Germany insists on generating trade surpluses within the eurozone.

Applying the same synthetic competitive devaluation policies in the entire eurozone will not solve matters, but simply transport the problem onto the global stage, increasing the risk of international protectionism and an implosion of international trade. 

I therefore welcome the final communique of the G-20 meeting in Moscow which reads in paragraph 5:

"We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open."

Let's all hope that these words do not fall on deaf ears in Germany and the rest of Europe.

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    [1] For example, as the availability of mortgages to construct the highly lucrative mortgage-backed CDOs was limited, Wall Street quants simply designed synthetic CDOs using CDS to reflect the risk exposures of mortgages, thus creating an unlimitless universe of CDOs....the perfect weapon of financial mass destruction.   

    [2] Unit labor cost = average cost of labor per unit of output.