VoxEU Column Global crisis

The ‘original sin’ in the Eurozone

Eurozone membership seemed to shield economies with structural problems from the “original sin” – the obligation to borrow in foreign currency while the ability to pay is in domestic currency. This column argues that the sin is still with Greece and other Eurozone nations with weak institutions. Reforms that boost the nation’s competitiveness or the government’s fiscal positions reduce short-term government revenue directly or via a recession. Solving the problem will require coordinated Eurozone intervention to correct internal imbalances

Among the main advantages of participating in the Eurozone – along with ruling out currency risk – is the fact that countries can issue debt in their own currency at reasonable prices, taking advantage of a large and thick market for euro-denominated bonds.

The balance sheet problem

The experience of many crises around the world has made it clear that this is not a negligible advantage. When governments and firms borrow in foreign currency, potential gains of competitiveness from exchange rate depreciation are easily dwarfed by losses from deteriorating balance sheets: the real value of their liabilities increases proportionally to the rate of depreciation.

This balance sheet problem has especially plagued Latin America, where, for many reasons, borrowing countries had little choice but to issue dollar denominated debt. The economic literature labels this pathology ‘the original sin’; a borrower with the original sin is exposed to the adverse balance sheet effects of depreciation (see Hausmann and Panizza 2010).

With the recent crisis in Greece comes the realization that, for many countries in the Eurozone, difficulties in ensuring the sustainability of their fiscal policy is compounded, and in part rooted, in a progressive loss of ‘competitiveness’. A large debt requires fiscal consolidation; low growth prospects make the fiscal measures particularly harsh.

‘Internal’ devaluation: Does it work with large public debt?

A possible way out – one oft-heard argument goes – is to regain competitiveness by some forms of internal devaluation; domestic costs must fall (Domingo and Cottani, 2010). In a critical situation, this could be done by decree. Namely, the government could coordinate an across-the board adjustment in wages – all wages, not just the government ones – driving down the prices of domestically produced goods and services. Such a measure is supposed to unleash growth prospects, complementing the government effort to fix public finances. The Baltic countries which had some experience with similar policy actions, claim to have enjoyed some degree of success – undoubtedly related to their polity (determining their ability to agree on difficult decisions), their relatively high growth potential, and, last but not least, a small stock of public debt.

Leaving aside the issue of whether internal devaluation by decree is politically and institutionally feasible for larger countries, the question remains: Would it work in economies with a large stock of outstanding public liabilities?

For a country with a debt to GDP ratio as high as 100%, an internal devaluation of 20% (a common estimate of what is ‘needed to restore competitiveness in the South of Europe) amounts to a corresponding increase in the value of its debt in real terms. The government benefits from paying lower public sector wages, but correspondingly, tax payments from income taxes go down. With a large stock of public debt, the bulk of the effects is likely to go through the government ‘balance sheets’, as stressed by the original-sin literature. With falling domestic prices, the government simply owes more to its creditors, in units of domestic production.

A similar issue of course arises for private debtors. Firms that own in euros will see their local costs drop with the nominal wage adjustment, but so will drop their revenues from the local market. The main benefits will accrue to exporters, which may have room for discriminating across markets, letting their foreign prices adjust by less than the domestic ones.

The only hope is that the internal devaluation would raise growth prospect so much, that the increase in the cost of debt in terms of domestic goods is more than compensated by the increase in the volume of production, and therefore in the flow of tax revenues and savings on social spending for the government, and the flow of profits for firms. This is certainly possible, but it is highly implausible that it would automatically follow from the internal devaluation. In most countries, the causes of slow growth and loss of competitiveness are structural.

Common currency doesn’t shelter nations from the “original sin”

But if growth problems are structural, internal devaluation can at best provide short-run relief from ‘competitiveness problems’. Its impact will mostly be felt via the real value of public and private liabilities. A common currency does not really shelter countries from the problems associated with the ‘original sin’.


Unfortunately, there is no easy way out.

  • For countries in need of strong fiscal correction, similar balance sheet problems materialize even in the absence of an explicit policy intervention on domestic costs, as fiscal consolidation is bound to produce internal deflation, relative to average prices for the Eurozone as a whole.
  • Whatever the modalities of internal devaluation, the associated balance sheet effects obviously raise the hurdles for designing programs which put the entire burden of adjustment on weak countries.
  • It will be difficult to get out of the current juncture without some form of coordinated Eurozone intervention to correct internal imbalances.

This ranges from mechanisms linking internal devaluations to assisted debt restructuring to the adoption of expansionary policies raising (investment) demand in surplus countries – a ‘Plan B’ which has often been misspelled politically, but makes lot of sense both from a national and an international perspectives.


Cavallo, Domingo and Joaquín Cottani (2010), “For Greece, a “fiscal devaluation” is a better solution than a “temporary holiday” from the Eurozone", VoxEU.org, 22 February.

Hausmann, Ricardo and Ugo Panizza (2010), “Redemption or abstinence?”, VoxEU.org, 21 February.


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