Internal devaluation in currency unions: The role of trade costs and taxes

This paper studies export adjustment to negative shocks in currency unions. I consider the hitherto ignored role of trade costs and taxes in internal devaluations, which have been brought to the fore of international policy during the recent euro periphery crisis. Trade costs can limit the pass-through of internal devaluation on export prices. Using data on export prices "on the dock", I document that higher trade costs are associated with a lower reduction of export prices relative to domestic prices in the euro periphery. Furthermore, VAT (in theory trade neutral, but in practice much higher on tradables) hikes prevent the required shift of resources towards tradables. I show that the real exchange rate (RER) adjustment was heavily affected by indirect tax hikes, by comparing headline RER and tax-adjusted RER. I then build a standard New Keynesian small open economy model with sticky wages and prices, incorporating trade costs and indirect taxes (allowing for VAT imperfections), and show that both these frictions, but especially trade costs, can be quantitatively crucial in affecting export growth, more so than either product markups or wage rigidity. I apply the model to data for Greece, the least successful of the euro periphery fiscal devaluation programs, and show that it can account for the most salient features of the data; trade costs explain the failure to substantially raise exports, and taxes the initial small fall in exports.