The Effects of Wage Moderation: Can Internal Devaluations Work?

IMF Blog, November 17, 2015

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Devaluation boosts export competitiveness and curtails imports by making them more costly; this generates financial resources for countries in trouble.
Countries in a currency union cannot devalue externally; internal devaluation (wage cuts or wage moderation) is an alternative to boost competitiveness.
Key question: Can internal devaluations work, especially when several crisis-hit countries undertake them simultaneously?

Policy considered for simulations: a 2 percent reduction in wage (and price) inflation.
Model: a large-scale model of the world economy with individual blocks for 11 euro area economies, including five “crisis-hit” economies that suffered large capital flight.
Two critical factors determining short-run outcomes:
- the number of countries undertaking wage moderation;
- the actions taken by the central bank.

If a single euro area crisis-hit economy undertakes wage moderation:
- The net effect on output is positive for that economy and for the entire euro area.
If all crisis-hit economies undertake wage moderation together:
- These economies account for some 30 percent of the euro area total GDP.
- Their output still expands, albeit to a lesser degree than the single-country case.
- If the central bank can cut policy interest rates, output also expands in the entire euro area because:
- Lower policy rates reduce long term interest rates, boosting investment and consumption of durables.
When policy interest rates are at the zero lower bound:
- Cuts in policy interest rates are not available to offset adverse spillovers.
- Unless other actions are taken to lower long term interest rates, euro area-wide output contracts in the short run.
Quantitative easing alternative:
- If the central bank takes actions that result in a 50 basis point reduction in long term interest rates, output in the crisis-hit economies and the euro area as a whole rises modestly in response to wage moderation.
Role of structural reforms:
- If European Union economies implement the structural reforms they committed to under the Group of Twenty initiative launched by Australia in 2014, output increases further.
- Structural reforms that boost productivity have a stronger, supportive effect on consumption and investment in the short run than reforms that boost labor supply.

Wage moderation can boost competitiveness and exports, but lower nominal wage growth and lower inflation (or deflation) can suppress domestic demand and increase the real burden of debt; competitiveness and aggregate demand effects work in opposite directions.
Internal devaluations are more effective when supported by accommodative monetary policies that lower long term interest rates.
At the zero lower bound, monetary policy can still act via quantitative easing to lower long term interest rates; a 50 basis point reduction is simulated to yield modest output gains.
Structural reforms complement wage moderation, with productivity-enhancing reforms providing stronger short-run support to consumption and investment than labor-supply-enhancing reforms.
Policymakers should consider spillover effects: wage moderation by a set of euro area crisis-hit countries can have adverse effects on output in the rest of the euro area unless offset by supportive monetary and structural policies.

The IMF has consistently advocated a comprehensive package addressing both aggregate demand and aggregate supply.
On the supply side: emphasis on structural labor market reforms to lower natural unemployment or raise labor force participation; staff advice underscores benefits of structural reforms.
On the demand side: early advocacy for supportive monetary policies, including quantitative easing, to boost aggregate demand in the euro area.
An explicit incomes policy to engineer an internal devaluation has not been part of any IMF-supported program for euro area countries.
The paper’s results highlight that adverse spillover effects on output in the rest of the euro area should be taken into account if internal devaluation policies are considered by multiple crisis-hit countries.

Jorg Decressin, Prakash Loungani — November 17, 2015 — The Effects of Wage Moderation: Can Internal Devaluations Work?

Staff Discussion Note
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