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Can struggling eurozone countries achieve the necessary ‘internal devaluation’– and at what political cost?

27 Sep 2012

27 September 2012 

With widespread anti-austerity protests sweeping Madrid, Athens and Lisbon, Open Europe has published a new briefing looking at the degree of ‘internal devaluation’ needed in struggling countries to keep the Eurozone intact – and whether citizens are likely to be able to stomach such adjustments. 

Open Europe’s Head of Economic Research Raoul Ruparel said:

“The history of the Baltic states – and to some extent Ireland – shows that large scale internal devaluation is fully possible in certain circumstances. But, against a backdrop of plummeting real GDP, internal devaluation also produces a politically explosive combination of falling wages and rising unemployment – all leading to a reversal in living standards. This is the eurozone’s great curse: do what’s economically necessary but risk massive political and social fallout.”

To read the note in full, please click here:


  • Struggling countries in the eurozone – Portugal, Italy, Ireland, Greece and Spain (PIIGS) – do not have the option of currency devaluation to get their economies back on track. All adjustment must instead be achieved by nominal prices, wages and asset values falling – so-called ‘internal devaluation’. This means that the population will have to pick up all the slack through falling wages, fewer social benefits and less job security. Therefore, the risk of political and social fallout – through strikes, riots or even wider political unrest – increases massively.

  • It is clear that the PIIGS need to undergo far-reaching structural reforms to improve their labour and product markets in order to regain competitiveness. Failing this, the stronger euro countries will be paying for the weaker ones indefinitely in a transfer union. The alternative is a eurozone break-up.

  • Spain, Italy and Ireland, in particular, can still in theory achieve the internal devaluation needed to become reasonably competitive with Germany. By 2011 Spain had achieved over 50% of its scheduled internal devaluation, while Ireland has managed over 80% and Italy has to reduce its labour costs by another 10% (although it is yet to put the policies in place to do so). However, Portugal is a borderline case (having achieved 40% of its scheduled adjustment) as, along with Greece, it is unclear whether it will be able to make the necessary cost reductions needed.

  • The experiences of the Baltic states show that large-scale internal devaluation is both economically possible and desirable, in terms of returning to economic growth. However, the Baltics’ adjustment was preceded by very rapid GDP growth. Significant contraction in wages and GDP had less perceived effect since the population had yet to consider the pre-crisis standard of living as the norm. In contrast, in Greece and Spain, high wages, social benefits and public services have been a feature of life for decades, meaning that it is far more challenging to get voters to accept anything less.

  • To illustrate the political challenge at hand: a 17% contraction in Greek real GDP by 2013 (expected by the IMF) puts Greece back to 2002, meaning that Greek GDP per capita will have fallen from over €16,000 in 2007/8 to under €13,000. Similarly, a 20% reduction in the Portuguese economy would take it back below its 1995 level of output, a reversal of 17 years – almost an entire generation lost.

  • The question is whether the PIIGS’ populations will be willing and able to accept such rapid adjustments. There is no way to say for sure when the political limit for cuts and austerity will be reached. However, protests on the streets of Athens and Lisbon, and widespread discontent in Spain illustrate that limit may not be far away.

  • In the wake of EU/IMF-mandated cuts, perhaps the most worrying trend in the PIIGS is that trust in the EU is plummeting. In the past, ‘Europe’ has been seen as a stable counterforce to unpredictable national politics but, on average, trust in the EU amongst voters in the PIIGS has fallen from 55% in 2001 to 25% in 2012.

  • If both the EU and national politicians are so deeply mistrusted by voters, it is difficult to see how politicians will have the mandate to continue to pursue internal devaluation. Large-scale internal devaluation is economically necessary but may prove to be politically explosive, at least under the current timeframe envisaged. Crucially all other existing currency unions also rely on a common fiscal backstop, therefore although internal devaluation is necessary it is alone unlikely to be sufficient to solve the eurozone crisis.


1) For more information, please contact the office on 0044 (0)207 197 2333 or the author Raoul Ruparel on 0044 (0)757 696 5823.

2) Open Europe is an independent think-tank calling for reform of the European Union. Its supporters include: Lord Leach of Fairford, Director, Jardine Matheson Holdings Ltd; Lord Wolfson, Chief Executive, Next Plc; Hugh Sloane, Co-Founder and Chief Executive, Sloane Robinson; Sir Stuart Rose, former Chairman, Marks and Spencer Plc; Jeremy Hosking, Director, Marathon Asset Management; Sir Henry Keswick, Chairman, Jardine Matheson Holdings Ltd; Sir Martin Jacomb, former Chairman, Prudential Plc; Lord Sainsbury of Preston Candover KG, Life President, J Sainsbury Plc; Michael Dobson, Chief Executive, Schroders Plc; David Mayhew, former Chairman, JP Morgan Cazenove; Tom Kremer, Chairman, Seven Towns Ltd. 

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