Nova workboard

a blog from young economists at Nova SBE

The compensatory variation of the macroeconomic adjustment

If prices increase, we would not be able to buy with the same money the same number of things. How much shall we give to a person in order to make her as well off after this increase, as she was before? With how much shall she be compensated with? This is the compensatory variation, a truly important concept at Economics that is mainly concern with society’s well being.

In this post I pretend to apply this concept to a concrete case.

One may be far from reaching a solution to the current crisis, but when we achieve it, we will still be far from getting everyone better off. One thing that one can be sure about that solution is that it involves a general decrease in prices compared with our commercial partners.

Between 1999 and 2003 our unit labour costs grew 25% compared with euro zone’s 9%. Concomitantly, prices in the non tradable sector (not exposed to international competition, e.g. services, construction…) grew 26%, compared with the euro zone’s 11%. These are inputs of the transactional sector (companies exposed to international competition), which explains our country’s growing lack of external competitiveness.

We would need something as a 30% decrease of our general wages and of non tradable sector profits by reducing its prices, in order to reduce the costs of the tradable sector. Having in consideration that our consumption is composed by 50% of each tradable and non tradable goods, this means there would be something as a 15% general price decrease (since the price of non tradable goods would fall 30% and the price of tradable would not fall since it is defined in the international markets).

We do not know when this is going to happen, neither how to achieve it (we may leave the euro and the depreciation of the “escudo” would allow this to happen, or maybe through an internal devaluation that would take much longer…), but that is not the point of this post.

What I would like to address is how to compensate for the families and companies that will get worse off (in this case the compensating variation differ a little bit from the standard one, because we are considering a decrease in prices that will make someone worse off). The price decrease of 15% won’t make everyone better off, since it will happen through a decrease on wages and on non tradable profits.

As explained previously this could happen by leaving the euro because escudo’s depreciation would decrease the purchasing power of wages and profits, since all the imported goods would become more expensive. The alternative theoretical framework is the internal devaluation. This would happen by the decrease in wages due the lost of employees’ wage bargaining power and by the fall in profits due to a depressed demand. Both these phenomena caused by the high levels of unemployment would plunge prices.

The most dramatic situation will be for debtors, because, since debt maintains the same nominal value, the decrease in prices makes the real value of their debt became much higher. Imagine that a debt of 100€ over a general price of 2€ equals 50 bundles, if price decreases to 1€, then the real value of the debt will be 100 bundles. Families and companies debt equals about 240% of GDP, many of these will became delinquent for sure.

Due to this change in prices we should compensate these agents increasing their income. But how could the government do this? First it should take from those who randomly benefit from the decrease in prices.  The debt we owe to ourselves (in opposition to the one we owe to foreign countries) equals around 220% of GDP. Those who have financial assets will randomly become better off because the real value of their asset, due to the price decrease, will rise. The government may tackle this injustice taxing the extra value of their assets, making them as well off as before the price decrease, and using that revenue to compensate for the debtors. Taking from the saver to give to the debtor may sound strange, but since none is responsible for the price change and since the saver will continue as well off, this is completely fair.

Not being sufficient, the government may also transfer money from the taxpayers that get better off with the higher economic growth and lower unemployment that the increase in exports may fuel. In utilitarian terms, it makes sense to move some money from those who are better off to the ones that are worse off because that amount of money would grant more utility to the latter, hence increasing well being. However, this tax could discourage some entrepreneurs from exploring all the business opportunities in the export industries, hence not fostering distributable economic growth that much. Basically, you cannot have your cake and eat it too. It is obvious that we would also need some support from the European budget.

The funds to compensate those who get worse off cannot come from nowhere. Economics can give us the tools to find the best solutions making at least someone better off without making anybody worse off. Thus, considering the two previous situations and after the change in prices, that is what happens here.

Diogo Silva Pereira Teles Machado nº 546