Internal Devaluation – Is It Necessary

Most observers are agreed that the economic reform process in Barbados seems to be proceeding at a glacial pace. Some think that this is just as well, since it is the wrong medicine, it irritates the palate, and that recovery of the patient could be assured by less disagreeable means. The medicine in question is […]

By Charles Skeete

August 12, 2014

MedicineMost observers are agreed that the economic reform process in Barbados seems to be proceeding at a glacial pace. Some think that this is just as well, since it is the wrong medicine, it irritates the palate, and that recovery of the patient could be assured by less disagreeable means. The medicine in question is internal devaluation – used here to include not only reducing labor costs and improving productivity as it is usually defined, but also fiscal consolidation. I believe that the medicine is necessary and that the administering of it should be done on a stricter time schedule. Here is why.

After five years of near zero average annual growth and an anemic export sector, for me it is self-evident that we need to restore the competitiveness of the Barbados economy. There is some disagreement about how this should be done.

The orthodox remedy of devaluation of the currency has been ruled out as inapplicable to a small open economy like ours, or as political suicide, or both. It is for practical reasons, therefore, off the table for the time being, so I will not annoy the reader with a discussion of its costs and benefits. Nor will I point out that, like diplomacy and certain bodily functions, it is one of those things that circumstances might dictate you have to pursue, whether you want to or not.

I turn next to the favorite remedy of the optimists and politically ambitious: stimulus of one kind or another. The justification for this option is that it would restore growth and thereby obviate the necessity for austerity and its counterproductive – not to mention unpleasant – side effects. Besides, stimulus feels good.

The trouble as always with stimulus as a remedy for a depression that has lasted a long time is how to finance it. After many years of expansionary fiscal policies and weak revenues, we are faced with a fiscal deficit that approaches 12% of GDP and a Gross Public Debt that approaches 100% of GDP. More importantly, while stimulus may make it possible to maintain consumption levels in spite of high production costs, stagnant output and weak external demand, by itself it does little or nothing to restore international competitiveness.

The grim picture of fiscal deficit and mounting debt has not prevented some from proposing, even now, that private sector stimulus, tax cuts for consumers, and selected government stimulus are preferable to internal devaluation as defined above. In case no one remembers, over time and in one form or another, we have tried these forms of stimulus. They have had no lasting impact on growth nor are they fiscally sustainable.

We have also tried another suggested alternative to belt tightening that is resisted by some as a surrender of national patrimony, but promoted by others who see it as a way to avoid fiscal consolidation. That suggested alternative is privatization. Faced with a sharp drop in capital inflows and a widening current account deficit, privatization can in some circumstances play a role in temporarily alleviating balance of payments and fiscal pressures. In addition, it can be a vital element in bringing about greater efficiency in what are now public enterprises. However, I believe we are faced with a structural deficit (one that persists even if the economy returns to full capacity) and not just a cyclical fiscal deficit (one that will correct itself when growth returns). If we wish to avoid recurring cycles of fiscal deterioration followed by adjustment (the 1980s, the 1990s, and now in the second decade of the Twenty First Century) we must adopt more fundamental reform of the public sector than the mere sale of government assets.

If currency devaluation, stimulus or privatization by itself, are not effective remedies for what is ailing us, we need, as the authorities are now doing, to try the one remaining legitimate remedy: internal devaluation. Unfortunately the consensus in support of this option is weakening in some quarters as the euphoria engendered by the “anything but currency devaluation” mantra has begun to fade in the face of the unfolding difficulties in implementing the reforms necessary for an internal devaluation.

In the first place, a cut in the nominal wage faces formidable constitutional and political obstacles. In the second place, while increases in productivity – for example, by means of layoffs — face fewer legal obstacles than a cut in the nominal wage, they still have to be negotiated with a union movement that wields considerable political clout. In short, a reduction in nominal wages — the chief means of achieving a reduction in production costs – is perhaps harder to achieve in Barbados than in any other democratic country. For example, we seem to be making very little if any progress in the reform of the network of statutory boards that have become an entrenched part of the public service.

The hard reality of internal devaluation is that it has many moving parts, and this makes it difficult to implement. There is little doubt too that in the short run it depresses demand. Because it is difficult to implement and because it depresses demand, it leads to frustration and political discontent. And yet, I support this policy option, partly because it is on balance the least undesirable of the available alternatives. I also support it because I believe that reducing costs of the production of goods and services and fiscal consolidation are reforms that we need to undertake, even if we opted for the alternative of currency devaluation.

There is of course the option of doing nothing. But this is the most dangerous option of all. If a country does not grow in nominal terms faster than the interest on its debt, it has to increase its primary surplus (the surplus before paying the interest on its debt) by either cutting expenditures or increasing taxes, or both. This is close to where we are today with the added element of foreign borrowing to sustain reserve levels and maintain confidence. But without a vigorous internal devaluation program, we are merely muddling through. This is likely to reduce growth even more than internal devaluation and send us into a vicious downward spiral.

The IMF anyone?

Charles Skeete

Charles Skeete is the former Executive Director and Senior Advisor, Plans and Programs, Inter-American Development Bank.

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