Chart: Correlation between changes in government deficit and changes in exchange rate (click to enlarge)
Source: Europe Economics analysis on Federal Reserve and IMF data
NB Left-hand axis is percentage movement in the currencies’ exchange rates versus the Deutschemark, from the year indicated to the next year, relative to the average movement in exchange rates for the period 1981-98. Right-hand axis is the change in the fiscal balance as a percentage of GDP.
In the chart above we consider, for a selection of Eurozone members, what happened to the currency when government deficits rose or fell in the 1980s and 1990s – i.e. in the run-up to the euro. To understand what's going on, we don't need to go through all the details, but simply to get the following point: when the blue and the red bars are almost always on opposite sides of the x axis, that means that whenever the deficit is being cut the currency is tending to depreciate and vice versa. In other words, in those countries fiscal tightening tends to go along with currency depreciation. But if the blue and the red bars have no particular pattern, then deficit reduction did not normally mean currency depreciation.
So what do we learn? We see that in Belgium, Greece, Ireland and Portugal, the blue and red bars tend to be on opposite sides. In other words, in the 1980s and 1990s these governments only usually managed to cut their deficits when their currencies depreciated. However, the exchange rate depreciation was much smaller for Belgium and Ireland than for Greece and Portugal (indeed, for an extended period in the early 1980s the punt actually appreciated versus the mark). Average annual depreciation for the Belgian franc was a little over 1 per cent per annum and the punt a little under 1 per cent. For the escudo average annual depreciation was about 7.5 per cent and for the drachma nearly 9 per cent. So although there was correlation for Belgium and Ireland, it was much less material than for Greece and Portugal.
The lesson might well be that history suggests Greece and Portugal are likely to struggle to cut their deficits without depreciating their currency – and they can't depreciate within the euro.
No surprise there. But what might surprise readers more is that in the 1980s and 1990s there was relatively little correlation between deficit-cutting and depreciation for Spain and Italy. Their currencies were depreciating over this period, to be sure, but their depreciations did not typically accelerate whilst the deficit was being cut. The message might, then, be that for Spain and Italy history suggests no particular need for depreciation to go alongside deficit reduction, so no especial challenge to deficit reduction for these countries from being in the euro.