Monday, 22 February 2010

Free lunches (wrapped in vine leaves)

This quite clever proposal from Cavallo and Cottani sounds plausible at first but my immediate reaction is: how can it work?

The idea is to eliminate payroll taxes in Greece and instead raise VAT to 25%. This is meant to increase competitiveness while reducing distortions in the economy.

It feels like a magic solution - which naturally makes me suspicious. If the economy really needs a devaluation, then how can they miraculously solve the problems without one?

But then I realise that magic really can happen.

A devaluation is only a nominal change - it simply breaks people's money illusion and affects relative prices. In fact, a devaluation requires no real actions at all, although it does change the pattern of of future real demand. All the benefits of a devaluation can, in principle, be achieved through the coordinated individual choices of all the agents in the economy.

Of course such coordinated choices are highly implausible, which is why devaluation is a good shortcut to achieve them. But then why shouldn't other shortcuts work too?

The effect of the proposed tax changes is really just a general cut in wages and an increase in prices; and the price increase (for non-tradable goods at least) will not last long if people can't afford to buy stuff.

The lesson: nominal changes, by countering our cognitive biases, really can produce a free lunch.

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