Countries that have the luxury of their own exchange rate are able to eliminate any loss in competitiveness through an exchange rate depreciation, but (as is broadly recognized by now) UBS reminds that in a single currency area the only route available is an adjustment in relative wages.
In order to restore competitiveness, the periphery will have to endure a period of below-average inflation equal to the disequilibrium that an exchange rate adjustment would have delivered. While the fantasy of an orderly Greek exit is gradually being dispelled - as the market recognizes the almost instantaneous bank runs that would be exaggerated from current deposit withdrawals in Spain, Portugal, and Ireland - the euro's survival with any status quo is simply impossible - begging the question of 'so how do they get to the other side?'
The answer, instead of instantaneous devaluation (exit) - akin to tearing the (admittedly big) band-aid off, the devaluation will be undertaken over time to restore competitiveness, the periphery will have to endure a period of below-average inflation equal to the disequilibrium that an exchange rate adjustment would have delivered. This equilibrium 'devaluation' is impossible to know with certainty, but UBS estimates it is over 20% for Greece and 15% for Spain.
Competitiveness pressures and inflation convergence
Long-run inflation trends in the eurozone will be driven by competitive pressures. Countries that have the luxury of their own exchange rate are able to eliminate any loss in competitiveness through an exchange rate depreciation, but in a single currency area the only route available is an adjustment in relative wages.
In order to restore competitiveness, the periphery will have to endure a period of below-average inflation equal to the disequilibrium that an exchange rate adjustment would have delivered.
Indeed, this is exactly the approach we adopt to estimate the long-run inflation prospects in a single currency zone – we quantify the size of the exchange rate disequilibrium and assume that the disequilibrium is eliminated gradually over a period of time.
Estimating the exchange rate (inflation) disequilibrium
The equilibrium exchange rate is impossible to know with certainty, but conceptually one can think of it as the rate consistent with a country maintaining its internal and external balance. The internal balance can be thought of as full employment and the external balance can be proxied by the current account balance. Taken together, the exchange rate is at equilibrium if unemployment is close to its equilibrium level and the current account is in balance.
We estimate the size of the disequilibrium for a selection of euro-area economies. Chart 5 below summarises our results.
For those of a technical bent of mind, Chart 5 has been generated from a set of econometric equations, one for each country, where we regress the real effective exchange rate against the current account balance and the unemployment rate gap (difference between actual unemployment and the non-accelerating inflation rate of unemployment, NAIRU).
REER = a + b Unemployment gap + c Current account balance + u
We then estimate the fair value by asking what exchange rate level is consistent with a zero current account balance and current unemployment compared with the equilibrium rate. The disequilibrium is the gap between the exchange rate and the fair value.
Chart 5: Currency Misalignment In The Euro Area
As discussed above, in a single currency area, real exchange rate misalignments can only be eliminated by relative adjustments to unit labour costs, but if you assume unchanged productivity growth, the brunt of the adjustment will have to take place through wages and inflation. Greece is running a large current account deficit, and unemployment is high. Under the current structure, unless we allow for a large depreciation of the euro, the economy will have to deflate its way to becoming competitive. Germany, on the other hand, is running a large current account surplus, and unemployment is well below the NAIRU. Our simple calculations suggest that Germany will experience a short period where inflation exceeds the euro-area average.
How quickly that disequilibrium will be eliminated is hard to know, but if we assume a gradual adjustment, say over a 10-year period, the 20% real exchange rate overvaluation in Greece will be eroded by 2% each year, the 15% in Spain by 1.5% each year, and so on.
How patient will the market be in waiting for the promise of integration to cover this slow and steady competitive devaluation; or alternatively how patient will Greece's poverty-stricken population put up with it? The reflexive nature of the market will accelerate any perceived move in this direction... a 'painless' 15-20% devaluation in Greece and Spain backed by the ECB's promises seems to us the stuff of hopes and dreams and unicorn farts.