Harvard University’s Gita Gopinath: Stimulating Europe’s Growth
With the troubled European economies struggling to restart their economic growth, while grappling with extreme budget constraints, an up and coming, stellar economist from Harvard has proposed a remarkably simple solution. It is referred to as “fiscal devaluation” and it enables countries to generate growth through exports, without resorting to devaluing their currencies
Meet Gita Gopinath, the 41 yr. old Professor of Economics at Harvard University, whose solution was recently implemented by France’s President Francois Hollande, as a mechanism to revive France’s languishing economy.
Gita, tell us about the concept of fiscal devaluation.
Fiscal devaluation, by its name is an alternative to an exchange rate devaluation that is engineered using fiscal instruments. There are several ways to engineer one. One “remarkably simple alternative” is to increase value added taxes and cut payroll taxes. Countries in the euro zone, who do not have their own currency to devalue, can use the VAT-payroll tax swap to revive growth through exports. By increasing value-added taxes while cutting payroll taxes, a government can affect gross domestic product, consumption, employment, and inflation much as a currency devaluation would. Essentially, the higher VAT raises the price of imported goods as foreign companies pay the levy on the products and services they export to that country. The lower payroll tax helps offset the extra sales tax for domestic companies, reducing the need for them to raise prices. Since exports are VAT-exempt, the payroll cost saving allows producers to sell goods more cheaply overseas, simulating the effect of a weaker currency. And finally, the policy also can help on the fiscal front, as increased competitiveness can lead to higher tax revenue.
The original concept behind fiscal devaluation goes back to John Maynard Keynes, who proposed increasing import tariffs and cutting export subsidies as an alternative to a currency devaluation (when countries were on the gold standard). Euro zone rules would disallow any intervention that uses tariffs and subsidies. This is why we push the alternative of VAT and payroll tax changes. It has often been conjectured that fiscal taxes can substitute for currency devaluation, but this has never really been proven. This is what we set out to figure out in our research. Initially we were skeptical that a couple of tax instruments would do the job regardless of the details of the specific economy we were applying it to. To our surprise we did find that indeed a VAT-payroll tax swap worked exactly (not approximately) as a currency devaluation and this was insensitive to a large number of details about the economy.
We started work on this idea a couple of years ago. My co-author, Farhi, is a macro economist working on public finance issues, my other co-author, Itskhoki, is a trade economist and I work on exchange rates. The three of us were able to use each other’s expertise to develop the idea.
Are there any initial positive signs resulting from France’s implementation?
Well, President Hollande recently has implemented a $27 billion tax cut for French companies and recently, Louis Gallois, former Airbus Chief, was quoted as saying that France was starting to turn the corner in a business-competitiveness report commissioned by Hollande. However, in my opinion, the intervention was too small and not executed as well as I would have liked. The size of the intervention in payroll taxes is too small to make much of an impact and the VAT tax increase has yet to be implemented (You really need to do both at the same time). Further, there have been many other tax increases in France, in recent times, that have the effect of undoing the benefits of a fiscal devaluation. The payroll tax cut is however hailed as the one pro-business development in France in recent times, so that is a good sign.
Countries whose central problem is a loss of competitiveness would benefit from a fiscal devaluation. I would say that Spain and Portugal are candidates. Now of course, if everyone did a fiscal devaluation no one gains (same as a currency devaluation). One imbalance that is often pointed out is that Germany runs a trade surplus relative to all other countries in the euro zone. A policy intervention that might be a good contribution for Germany to the euro zone is to do the reverse of a fiscal devaluation. In 2007, Germany raised its VAT and cut payroll taxes. It might consider reversing such moves, so that its competitiveness is realigned with that of the other countries in the euro area.
Finally, how would you describe the EU’s current prognosis and how do the next 12 months look from your perspective?
These are interesting times. The one good news that came out of the EU in the past few months was the decline in sovereign spreads for the troubled economies of Spain, Portugal, Greece and even Italy. This was a combination of the “Draghi put” (to stand by the euro at all cost) and the extremely loose monetary policy in the rest of the developed world. Now with the U.S. slowing quantitative easing and with German elections around the corner (September), the risk that sovereign yields will rise again is a real one. With the larger EU economies like France and Italy still stagnant, the impact on these economies of even small increases in yields can be large. We already see a lot of volatility in markets with the decline in quantitative easing in the U.S, so the next few months will be critical to the success of the euro project.