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Internal Devaluation and Labour Market Trends during Ireland's Economic Crisis

Internal Devaluation and Labour Market Trends during Ireland's Economic Crisis

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Authors

Tom McDonnell and Rory O'Farrell

Summary

Countries within a fixed exchange rate regime such as the euro area are unable to reverse a loss of competitiveness and balance of payments imbalance through a nominal devaluation of the currency. For a country in this predicament the loss of competitiveness can only be reversed internally, through relative gains in the efficiency of production, or through action to reduce individual domestic prices. In practice, direct action on domestic prices to induce so-called ‘internal devaluation’ usually refers to policies aimed at reducing wages and other labour costs. Historical experiences with internal devaluation have not been happy ones - ‘successful’ internal devaluations have been accompanied by falling demand and recession.

Internal devaluation strategies were proposed from early on in Ireland’s economic crisis and were based on the claim that a loss of competitiveness explained, or at least contributed to the crash. This paper examines whether internal devaluation and changes in labour-cost competitiveness can adequately explain post 2008 employment trends in Ireland. Alternative explanations are also explored, with particular attention given to the unsustainable nature of economic and labour market developments in the period leading up to the 2008, and the collapse of the construction sector and subsequent swing to fiscal austerity post 2008. We do not find a strong causal link between internal devaluation policies and the substantial movements in employment post 2008. The fall in domestic demand and accompanying loss of employment has far outweighed any employment gains arising from improved competitiveness.

Irish wages are now relatively lower than in other EU countries compared with 2008. However, this is not primarily due to a coordinated policy, but is instead due to a relatively weaker Irish economy and to the absence of wage pressure in a post-crash environment characterised by high unemployment. The decline in nominal unit labour costs is largely explained by a compositional shift away from the labour intensive construction sector.

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