The eurozone's competitiveness conundrum
The outlook for internal devaluation is mixed in Spain and Portugal but reform has come to a halt in Italy. It's high time Northern Europe did some heavy lifting by tolerating more inflation - the only pro-growth game-changer in town.
There were some fighting words from the Estonian prime minister on Friday morning. According to wire reports, Andrus Ansip slammed eurozone’s political leadership, arguing austerity measures inflicted on Greece have been timid and the process of internal devaluation in peripheral Europe, more generally, has failed to gather pace. The Baltic economies can claim some moral and practical authority on the process of internal devaluation. In recent years, the region has famously ensured domestic wages and prices were adjusted downwards to boost competitiveness, rather than an external devaluation of the nominal exchange rate.
The jury is out on whether this strategy is worth the social toll and whether it’s a model that is easily exportable to its western neighbours, not least because of what the Nobel Prize-winning economist Amartya Sen describes as "relative deprivation" theory. In short, in welfare economics, people feel particulary discontented when they compare their situation to others or their previous life experiences. While eastern Europeans have endured the economic costs of the Soviet-era, western Europeans have, in relative terms, had it easier, underscoring why it’s easier to impose austerity in the Baltics, compared with peripheral eurozone.
However, Ansip’s comments lack some nuance: with the exception of Italy and Greece, eurozone peripheral economies have recouped more than half their losses in price competitiveness, according to Commerzbank.
The following charts highlight improving wage and productivity data, and how unit labour costs should continue to fall. In summary, Italy needs to engineer a massive correction in wage costs but it’s a better story elsewhere:
|“Spain and Portugal have liberalized the wage-formation process. Spanish companies may now opt out of
centrally negotiated wage agreements and reach internal wage agreements with the unions. They can even pay lower wages than collectively agreed without the approval of the unions if the company faces economic difficulties: companies merely have to prove that they have posted losses or
that sales have fallen for three consecutive quarters. Moreover, the number of employees covered by a collective wage agreement has fallen significantly in the last three years and this trend will be reinforced by such measures.”
Productivity in Spain has jumped 8% since 2008, but the outlook is mixed:
|"Trends in productivity are mainly influenced by the economic cycle. If production falls, productivity also drops initially, as businesses adjust to lower production with a lag. It is therefore all the more remarkable that Spain and Ireland have significantly increased their productivity in
the past few years despite the recession and have hence reduced their unit labour costs. In Spain, productivity has risen by 8% overall since 2008. In Spain and Ireland this is mainly due to the fact that after the housing bubble burst, capacity in the construction sector was reduced very quickly and surplus labour was dismissed. Once this adjustment process is completed, productivity in both countries will no longer rise as sharply.
In the long-term, the productivity trend will be determined by technical progress. Only Italy appears to have detached itself entirely in the past 12 years. Productivity in Italy has risen only minimally (1.5%). In the eurozone as a whole, productivity gains were eight-times higher.
Italy’s productivity disaster appears to lie in the poor overall conditions for companies; according to data from the World Bank (the “Ease-of-Doing-business” Indicator), Italy ranks second-to-last within the European Union on this score.
So, with the notable exception of Italy, there has been some improvement in competitiveness. However, there is a long way to go. Northern Europe needs to adjust by tolerating inflation to boost the relative competitiveness of the periphery. In this context, market expectations for inflationary pressure in Germany is still dispiritingly low. Although the 10-year break-even rate at 1.81% is higher than the 1.26% registered end-May it's still too low.
As economist, Krugman fan and unabashed Keynesian Brad DeLong writes on Friday:
|"Now, if, as appears to be the case, Europe does not want its south to spend more than it earns and its north to spend less, wages, prices and productivity must shift. If we are not to look back in a generation and bemoan lost decades, southern European productivity levels need to rise relative to the north, and wage and price levels need to fall by roughly 30%, so that the south can pay its way with exports and northern Europe can spend its earnings on those products.
...Northern Europe could tolerate higher inflation – an extra two percentage points for five years would take care of one-third of the total north-south adjustment."
The eurozone has spent too many years using cyclical tools to try to solve structural problems – it's high time western Europe did some heavy lifting.