Competitiveness confusion reigns supreme

Many question how the heavily indebted European nations will get out of the mess they are in. Absent a break-up of the single currency unit, most economists point to a significant reduction in unit labour costs (through a reduction in nominal wages) as the answer. In fact, Nicolas Sarkozy has stated that France has to bring down labour costs to improve its competitiveness like Germany did a decade ago.  The question we are asking ourselves is if this so-called “internal devaluation” is the answer?

Competitiveness is a buzz word that gets thrown around a lot. But what is it exactly? The most widely used measure of competitiveness is unit labour costs (ULCs), the ratio of nominal wage growth to labour productivity. It is important to economists because they will deem an economy to be more competitive the lower the ULC is. This would suggest that an economy is more competitive the lower the share of the labour force’s contribution to GDP. Thus, in order to close the “competitiveness gap” that exists between unproductive countries (like Greece) and productive countries (like Germany), countries need to implement policies that will result in downward adjustments in relative wages.

In extremis, this means that the most competitive economy would have a labour share of GDP of zero (because wages are zero), and a capital share of GDP of 100%. Does this make sense? No.  Reducing the income generated by labour by reducing nominal wages will be a drag on economic growth, and several economists have investigated the impact that ULCs have on an economy. Kaldor’s paradox, put forward by Nicholas Kaldor in 1978, showed that the fastest growing economies in the post-war period also experienced faster growth in ULCs, and vice versa. This suggests that a higher labour share will not necessarily lead to a less competitive economy. The argument that many have been spouting that lower ULCs will lead to higher economic growth is a highly simplistic view, and may not reflect reality. Remember, those economies with the fastest growth rates in the 2000s, like Ireland and Spain, actually had the fastest rising ULCs over the same time period.

An increase in labour’s share of income can have a number of effects. Firstly, it has been shown that the propensity to consume out of wages is higher than that of profits, so if you really want to get an economy going, the trick is to increase the amount of money that gets into people’s pockets. And that is exactly what the central banks are trying to do, by flooding the financial system with cash.  Of course, there is another way to reduce ULCs to become more competitive and that is to increase productivity, which means working more efficiently for the same amount of pay. If ULCs fall due to productivity gains, the benefits will largely accrue to the business owner and not the worker.

However, workers are getting poorer as shown by the below chart. It is very difficult to stimulate consumption when real wage growth is negative, as it has been for the last four years in the largest European nations. £100 in 2000 is now worth £68 in real terms, and €100 in 2000 is now worth €78 in Germany, €59 in Spain, €74 in France, and €67 in Italy (all in real terms). For the last four years wage increases across Europe and the UK have not kept up with the pace of inflation.

Secondly, if nominal wages are rising then prices for goods will also rise, though they will become less competitive in international markets. This will have a negative effect on growth. Would workers in countries like Spain, where unemployment is currently 22.9% and inflation is 2.4%, accept a reduction in nominal wages to maintain their firms’ competitiveness and therefore keep their jobs? The point is, the overall result on GDP of a redistribution of income towards workers is ambiguous and depends on which of the two effects dominates.

Let’s have a look at a shift in the distribution of income towards capital. Initially, an economy will probably experience an increase in investment causing GDP to increase. However, sooner or later prices will fall because of excess capacity caused by both an increase in investment and fall in consumption. Capacity utilisation will have to fall, followed by a reduction in investment, a decline in income will follow, and then a fall in production and employment.

The major challenge facing Europe is a lack of demand. This is an underconsumption crisis. Reducing ULCs will not solve this underconsumption crisis through either nominal wage falls or productivity gains. If a worker wakes up tomorrow and can do the job of two people, then the business owner could sack the second person to keep costs down and improve profitability. In this example, productivity gains will lead to rising unemployment and a further deterioration in government finances through reduced taxes and higher transfer payments.

It is true that the growth rate of an economy will depend on the growth rate of exports, but the problem is the growth rate of exports depends upon world demand and how competitive those exports are in the international marketplace. We doubt an internal devaluation is the answer to Europe’s problems. To say that a reduction in ULCs will result in a rebound in growth numbers is wrong. You have to be producing stuff that people want to buy. Or you need your currency to devalue by enough to make your goods relatively cheap. This isn’t going to happen in Europe, where the euro has been remarkably strong given the sovereign crisis. The growth answer lies in getting credit flowing through the economy again, and central banks recognise that. It is important to realise that sometimes the obvious solution – like “we need to be more competitive” – is not always the right solution.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. Gareth says:

    “Does this make sense?”
    Sure, why not?  Your economy is entirely run by robots.  Everybody lives a live entirely of leisure, served by robots.  Sounds pretty good to me. They did it in Wall-E, after all.

    Posted on: 08/02/12 | 10:25 am
  2. Trevor Rothermere says:

    >>> Firstly, it has been shown that the propensity to consume out of wages is higher than that of profits, so if you really want to get an economy going, the trick is to increase the amount of money that gets into people’s pockets. And that is exactly what the central banks are trying to do, by flooding the financial system with cash. <<<

    Flooding the financial system with cash will not achieve this goal. The blueprint for this thesis is the Fed’s QE2, and we’re shortly to have a re-run to drive the point home.

    During QE2, investors grasped the long-term implications of this unprecedented liquidity, and sought safe-havens in hard assets, driving commodity prices higher (ironically, immediately generating the inflation they sought protection from…). The impact of a declining currency and inflated commodity prices acts as a “tax” on consumption, and stalls economic growth.

    That’s what happened during 2011. The US was fortunate that technical reasons suppressed WTI prices (compared to Brent), so their headwinds were attenuated compared to those faced by the rest of the world, who saw crude prices climb ~66%. Any wonder that global growth stalled?

    Fast forward to today. We have yet further “emergency” liquidity measures being announced or in the pipeline, and promises of easy money through til 2014. And the market’s rational response? To again immediately bid up prices of hard assets and commodities as a safe-haven from anticipated inflationary effects and/or currency devaluation. Having read the script for QE2, investors are likely to respond more forcibly and more quickly in this round of the “game”.

    So what can we expect to happen? Just as the prices of “essentials” were beginning to fall – giving central banks cover for this current round of further “emergency” measures – we’re already seeing those price falls reversing. Look at a price chart of Brent crude. While it will take some time for those price rises to make their way into headline inflation figures, the impact of elevated and rising prices will be swiftly felt by consumers, who’ll continue to see a large and growing portion of their wages absorbed by non-discretionary spending on the essentials such as food and fuel. With discretionary spending thus suppressed, economic growth will again stall.

    Our central banks’ easy money policies now have us trapped in a stagflationary environment. They know that declining real wages make economic growth very difficult, yet it’s their policies that are driving that same fall. 

    This will not end well. 

    Posted on: 08/02/12 | 11:38 am
  3. Jeremy Beckwith says:

    No quibbles with the analysis per se for the eurozone; but for  a small, export-heavy, open economy, it is possible to devalue internally , and this greater competitiveness to boost exports sufficiently to lead to economic growth. Here read Germany from 1995 to 2005, following the integration of East Germany and entering the euro at too high an exchange rate. Bearing down on ULCs did (in the end) lead to strong growth – hence why Germany is insisting on this policy for the periphery. The problem is the eurozone is NOT a small, export-heavy, open economy – in fact it is exactly the opposite, which is why we have the problems we have today. Someone teach Germany some economics please.

    Posted on: 08/02/12 | 1:52 pm
  4. Rower32 says:

    This is a very good post folks!

    Posted on: 08/02/12 | 2:50 pm
  5. Crysangle says:

    Not more credit . People reach a limit with regards to earnings and then what ? Create a speculative asset bubble for leverage … then ? We have been through that. Would you realize we might spend what we earn , no more no less , by expanding money supply we weaken its value , same net difference except there is an ability in the system to reward some and to punish others. What is the issue really ? To keep people active, to create productivity, to create demand, to keep the flow of money through society at a certain level, to keep GDP on a certain track, to increase the well being of the population, to ease the amount of work needed to achieve a similar level of wealth, to maintain the financial system or certain valuations ??? There are many ways to approach the topic , some inter relate well, others are conflictive. Below is an interesting addendum on the Geman labour force.

    Posted on: 08/02/12 | 7:26 pm
  6. Robert J says:

    So one of the arguments for having a positive inflation target is that inflation greases the labour market by keeping real wages in check – exploiting worker money illusion.

    But if, on the other hand, a reduction in real wages occurs in a recession, then this may prolong the downturn due to the negative influence upon consumption.

    Interesting trade-off between the goal of a competitive labour market in the long-term and the goal of supporting consumption in the short-term.

    Posted on: 17/02/12 | 1:23 pm

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