The Quirky IMF

The International Monetary Fund (IMF), which held its annual meeting in Washington in September has always been considered somewhat strait-laced. The lender has long encouraged old fashioned fiscal probity among its 187 member countries. But the winds of change are blowing at the fund’s DC headquarters. Instead of calling loudly for self discipline, the IMF has been putting forward a range of quirky ideas. In particular, has suggested a quirky technique called “fiscal devaluation” to ease the pain of retrenchment in the trebled nations on the periphery of the Eurozone.

Among their other problems, nations like Greece, Portugal and Ireland have become progressively less competitive since the introduction of the single currency. This led to bulging current account deficits. To restore the appeal of the exports, these countries thus face an unappetizing choice between humiliating devaluation, which would involve an exit from the Eurozone, or years of cuts in relative wages. Fiscal devaluation is the third option.

It works by lowering labour costs for domestic businesses – typically cutting taxes paid by employers – which makes them more competitive in the export markets. The lost tax revenue is then offset by a rise in value added tax, which falls more heavily on imported goods. Portugal has already started to trial this approach in a modest way.

Of course, the effects of this “cheater’s devaluation” don’t quite match the real thing. Shifting taxes in this way by about 1% of GDP may only raise exports by about 0.5% in the first year, the IMF suggests. As a result, it won’t totally eliminate the need for falling wages. And increase in VAT has other disadvantages, including that it tends disproportionately to hit the poor. 

The IMF doesn't say how these governments will make up the shortfall in their tax receipts which is another major problem on what to do next when employment taxes have fallen to zero but with options so scarce, the IMF unorthodox suggestion may gain in popularity on the other side of the channel.