complete. While managing debt ratios, GIPS need to ensure that fiscal policy is supportive of growth.

**_<u>Lesson 5. Exports do not just depend on lower wages, (and may not even be strongly affected by changing them).</u>_**

_<u>Export growth to counter the lower domestic demand during fiscal consolidation is a good idea, but wage cuts may not support export recovery when other structural factors (such as financial markets and the regulatory framework) constrain exports.</u>_ _<u>Exchange rates during consolidations.</u>_ During the post‐sovereign debt crisis period, the role of monetary and exchange policies during fiscal consolidation came under the spotlight. Policy makers grappled with how to support the economic recovery which stalled in the wake of the sovereign crisis. Several papers have examined the impact of relative prices on supporting export led growth during these periods. Research on expansionary consolidations stresses the importance of exchange rate depreciation in promoting exports and output during fiscal consolidation. Recent IMF research (IMF, 2015d) confirms the importance of real exchange rate dynamics in this regard, but also its complementarity with other policies. It finds that globally, a 10% real effective depreciation is associated with a rise in net exports of 1.5 percent of GDP on average; however, there is substantial cross‐country variation. Countries that have the greatest slack ‐ output below potential‐ and those with normally functioning domestic financial sectors should get the largest effects from real depreciation.<sup>4041</sup> Examining fiscal adjustment in OECD countries, Lambertini and Tavares (2003) find that successful adjustments (ones where debt/GDP falls) are preceded by large nominal depreciations and that depreciations have a significant and quantitatively large impact on fiscal adjustment. Giavazzi and Pagano (1990) highlight the important role played by monetary and exchange rate policies in Denmark and Ireland in earlier fiscal consolidation episodes. In Ireland for example, devaluation of the currency enhanced the credibility of government reforms and also boosted net exports. In Denmark, monetary/ exchange rate policy was used to enhance the credibility of government reforms as well. GIPS did not have recourse to nominal exchange rate depreciation nor could they implement monetary/exchange policies in the timeframe, direction and magnitude needed to support their specific fiscal and economic situations.

Research by Farhi et al (2011) and others considers situations in which a _fiscal devaluation_ may be used to simulate effects similar to an exchange rate devaluation. For example, an import tariff combined with an export subsidy could mimic a devaluation.<sup>42</sup> A fiscal devaluation is generally of two types: (a) a uniform increase in the import tariff and an export subsidy or (b) a uniform increase in the VAT with a reduction in the payroll tax.<sup>4344</sup> The authors do a calibration based on the features of Spain’s economy in 2008, and find fiscal devaluation to mimic a nominal devaluation in terms of welfare effects (changes in composition). The higher the wage rigidity, the larger the benefits from a fiscal devaluation (either full or incomplete), relative to no intervention. However, none of the countries adopted this policy, instead, the focus was on wage reductions to achieve internal devaluations. In this regard, the average annual wage fell 20% in Greece during 2009‐14; P and S had much lower falls. At the same time, Greece was the only country where the minimum wage was substantially reduced.<sup>45</sup> Figure 5b shows the real

> 40 The effect varies between 0.5% and 3.1% of GDP. Their estimates refer only to the direct effects of depreciation and do not include the impact of indirect effects, such as inflation expectations and interest rate movements, domestic demand etc. 41 Guajardo et al (2011) find fiscal contractions to have contractionary effects on domestic demand in OECD countries regardless of exchange rate systems. Note that this does not imply that exchange rate adjustment may not mitigate the effects. 42 There are instances where additional measures, such as a reduction in the consumption tax and an increase in the income tax may be needed as well.

> 43 In order to mimic a full fiscal devaluation, generally an investment subsidy and a capital income tax are also needed (otherwise firms have an incentive to substitute labor for capital).

> 44 Depending on the circumstances, as discussed in the paper, other tax adjustments may also be needed.

> 45 Euro depreciation also helped vis a vis non‐euro using trading partners.

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