Do some countries in the Eurozone need an internal devaluation? A reassessment of what unit labour costs really mean

Vox

Jesus Felipe, Utsav Kumar

The problem with Greece, Ireland, Italy, Portugal, and Spain is that they are uncompetitive and need to internally devalue – or so the argument goes. This column challenges this conclusion by pointing out that the measure used to back it up – unit labour costs – is flawed and misguided. Europe’s periphery lack of competitiveness is related to the types of products they export and not to the fact that their labour is expensive.

Along the periphery of Europe, there is supposedly a new crisis to add to the growing list, i.e. the crisis of “competitiveness”. Many analysts have concluded that workers in Greece, Ireland, Italy, Portugal, and Spain are too expensive compared with their far more efficient German competitors (Dadush and Stancil 2011). The argument seems to be that, in order to restore their competitiveness, these countries have just one option. Because they are all members of the euro, exchange-rate devaluation is out. For the same reason, monetary policy is out. And the monetary union has imposed fiscal rigidity, tying policymakers’ hands. That leaves only one route for adjustment: The labour market.

As a result, policy discussions are now focused on ways to lower unit labour costs. The drawback of this argument and discussion, however, is that the way unit labour costs have been calculated to reach the conclusion above is problematic. Unit labour costs are defined as the ratio of the nominal wage rate (in euros per worker) to labour productivity (in units of output per worker, e.g., number of automobiles produced per worker). The units are, therefore, euros per automobile. But this is not the way the unit labour costs that are being discussed are calculated.

In a new paper (Felipe and Kumar 2011), we discuss a number of problems with the recent work on unit labour costs in the Eurozone and the policy recommendations derived from it. We discuss four issues. The first two are conceptual. The third one refers to the comparison with Germany. And the last one is a comment on the empirical relationship between unit labour costs and growth. Europe’s peripheral countries are in trouble but the problem and solutions are unrelated to their aggregate unit labour costs.

The downside of aggregate data

First, most often, researchers use sector or economy-wide data when they calculate unit labour costs. This implies that they do not construct unit labour costs using physical data. Instead, the denominator is aggregate labour productivity, calculated as the ratio of nominal value added to a deflator, and then this is divided by the number of workers. This is a unitless magnitude. The two notions of unit labour costs, in physical terms and aggregate, are not the same; and the latter is not just a weighted average of the former.
Aggregate unit labour costs are shown in Figure 1.They increased in all Eurozone countries during 1980-2007. Greece and Portugal saw the fastest increases during this period.
Figure 1. Unit labour costs in the Eurozone

Source: OECD and authors’ estimates
If the aggregate unit labour cost cannot be interpreted identically to the one in physical terms, is there any alternative interpretation? The answer is yes. In Felipe and Kumar (2011), we show that the aggregate unit labour cost can be rewritten as the labour share in total output (value added) multiplied by the price deflator. This means that aggregate unit labour costs reflect the distribution of income between labour and capital.
One important implication of this consideration is that policymakers have to understand the consequences of a reduction in the labour share (and the consequent increase in the capital share) if they implement policies that lead to a reduction in unit labour costs. The most obvious one is a reduction in consumption.
Figures 2a and 2b show the two components of the aggregate unit labour cost, namely the labour share and the price deflator. They show that the increase in unit labour costs was due, exclusively, to the increase in the price deflator used to calculate labour productivity. Except in Greece, aggregate labour shares have declined or remained constant in the other 11 countries (and consequently, the capital share has increased).
Figure 2a. Unit labour costs, labour share, and price index


Figure 2b. Unit labour costs, labour share, and price index


Source: OECD and authors’ estimates. Note: The labour share and ULC are shown on the left-hand side axis. The price index is shown on the right-hand axis.
Second, if competitiveness is calculated through the aggregate unit labour cost, then we should also define the concept of unit capital cost, namely, the ratio of the nominal profit rate to capital productivity.
Figure 3 shows that unit capital costs increased in the 12 countries considered. This matters because looking at competitiveness from the point of view of unit labour costs puts the burden of adjustment on workers. However, we could equally argue that a country’s presumed loss of competitiveness is due to the fact that “machines are expensive given their productivity”.
Figure 3. Unit capital costs in the Eurozone

Source: OECD and authors’ estimates.
Table 1 provides a comparison of the increase in unit labour and unit capital costs for all 12 countries, for the whole period 1980-2007 and for the sub-period 1995-2007. It indicates that the purported “loss of competitiveness” by the peripheral countries of the Eurozone is not just a question of nominal wages increasing faster than labour productivity. In all countries, nominal profit rates decreased at a slower pace than capital productivity (Marquetii 2003 documented that, over the long run, capital productivity displays a declining trend. And Glyn 1997 showed that profit rates also display a declining long-term trend).
Table 1. Unit labour costs and unit capital costs in the Eurozone in 2007 relative to the respective levels in 1980 and 1995

	2007 relative to 1980			2007 relative to 1995
Country	ULC	UKC		ULC	UKC
Austria	1.46	5.39		1.02	1.55
Belgium	1.92	2.73		1.18	1.32
Finland	2.18	3.41		1.11	1.33
France	2.02	3.98		1.17	1.32
Germany	1.38	2.33		0.97	1.24
Greece	17.06	12.10		1.61	1.55
Ireland	2.63	7.02		1.40	1.85
Italy	3.80	7.26		1.30	1.53
Luxembourg	1.88	3.93		1.25	1.58
Netherlands	1.51	2.47		1.27	1.44
Portugal	8.94	10.71		1.42	1.44
Spain	4.04	6.85		1.40	1.72

Source: OECD and authors’ estimates
Third, the comparison of the unit labour costs of the peripheral countries with those of Germany is misplaced. Using disaggregated data (for over 5,000 products exported) we show that the “complexity” of Germany’s export basket is significantly higher than that of the southern European countries and Ireland’s. Table 2 shows that Germany exports a significant share, over 12%, of total world exports of the top 10 most complex products; and over 30% of the top one-third most complex products (those in groups 1 and 2). It is clear that Ireland, Spain, Portugal, and Greece hardly compete directly with Germany in many of the products that they export, and hence comparing their unit labour costs is probably misleading.
German exports are concentrated in the most-complex products of the complexity scale and the least-complex export group represents only 3.4% of Germany’s exports (Table 3). In the case of Greece and Portugal this group represents 33.1% and 21.7%, respectively, as in China.
Table 2. Share in world exports by complexity groups

Countries	Share in world exports
	Top 10	Top 100	1	2	3	4	5	6
Austria	1.73	1.62	1.58	1.49	1.10	1.23	0.85	0.23
Belgium	3.76	2.26	3.21	2.89	2.01	2.05	2.60	1.85
China	1.22	1.28	2.72	8.08	10.78	13.97	12.96	13.35
Finland	0.50	1.09	1.05	1.38	0.59	0.72	0.29	0.22
France	5.11	3.57	5.78	6.08	5.43	5.58	3.08	1.59
Germany	12.24	17.99	17.73	13.50	8.01	7.64	4.65	1.89
Greece	0.01	0.02	0.03	0.16	0.13	0.24	0.31	0.37
Ireland	1.25	0.80	2.71	2.26	1.21	1.50	0.51	0.11
Italy	1.40	3.07	4.04	4.30	3.15	3.87	4.69	2.56
Luxembourg	0.81	0.15	0.14	0.30	0.15	0.20	0.11	0.03
Netherlands	5.11	3.50	2.93	3.51	3.17	2.76	3.50	2.73
Portugal	0.05	0.04	0.30	0.23	0.48	0.48	0.56	0.52
Spain	0.23	0.88	2.23	2.36	1.70	1.85	2.46	1.28

Notes: *Figures are based on the averages of export values for 2001–2007. **Countries with population of less than 2 million (except Luxembourg) were excluded from the calculation of total world export.*** Products are divided into six groups, 1 is the most complex product group and 6 the least. The Top 10 and Top 100 correspond to the most complex products; ***The definition of product complexity is from Hidalgo and Hausmann (2009)
Table 3. Share in a country’s total exports by complexity groups

Countries	No. of products (RCA>=1)	Complexity Rank	Share in country’s exports
			Top 10	Top 100	1	2	3	4	5	6
Austria	1,369	8	0.23	6.17	30.38	23.29	19.00	14.99	8.83	3.52
Belgium	1,470	10	0.23	3.84	27.81	20.30	15.55	11.26	12.12	12.96
China	1,962	51	0.02	0.53	5.71	13.90	20.75	19.52	15.59	24.53
Finland	765	5	0.10	6.11	30.09	31.99	15.19	13.14	4.52	5.08
France	1,788	11	0.16	3.20	26.18	22.33	22.00	16.09	7.54	5.86
Germany	2,113	2	0.19	7.90	39.62	24.50	16.01	10.85	5.61	3.40
Greece	1,060	52	0.01	0.39	3.82	14.78	12.50	17.21	18.60	33.09
Ireland	421	12	0.13	2.28	39.06	26.27	15.60	13.79	3.97	1.32
Italy	2,239	24	0.06	3.47	23.16	20.06	16.16	14.12	14.54	11.96
Luxembourg	588	9	0.78	3.88	19.22	33.53	18.10	17.60	8.27	3.28
Netherlands	1,312	13	0.25	4.75	20.23	19.72	19.60	12.12	13.08	15.26
Portugal	1,188	53	0.02	0.42	15.32	9.84	22.09	15.57	15.53	21.66
Spain	1,745	28	0.02	1.89	24.18	20.80	16.53	12.77	14.46	11.25

Note: Same as Table 3
This analysis leads to the conclusion that if the underlying problem of Europe’s periphery were lack of competitiveness, it should relate to the types of products they export (vis-à-vis Germany) and not to the fact that their labour is expensive (their wage rates are substantially lower), or that labour productivity has not increased (it has significantly). The problem is that they are stuck in the manufacturing goods also produced by many other countries, especially the low-wage countries. Reducing wages would not solve the problem. What would an across-the-board reduction in nominal wages of 20%–30% achieve? The most obvious effect would be a very significant compression of demand. But would this measure restore competitiveness? We argue that it would not allow many firms to compete with German firms, which export a different basket, and in all likelihood it will not be enough to be able to compete with China’s wages.
A consequence of this analysis is that Europe’s peripheral countries should make significant efforts to upgrade their export baskets. Greece, Ireland, Italy, Portugal, and Spain should look upward and try to move in the direction of Germany, and not in that of China. Certainly this is not easy and it is only a long-term solution, more so because in a recession firms are unlikely to be willing to enter new products, but it is the way to move forward.
Fourth, it is important to remember that aggregate unit labour costs are not expected to lead to output growth. In the literature, this is referred to as Kaldor’s paradox (Kaldor 1978). Using data for the postwar period, Kaldor found that those countries that had experienced the greatest decline in their price competitiveness (i.e., highest increase in unit labour costs) also had the greatest increase in their market share. Fagerberg (1996) revisited this enduring puzzle by analysing the period 1978–1994 and concluded that the paradox also continues holding for this period.

Conclusions

We have argued that the recent debate about the need to reduce unit labour costs in the peripheral countries of the Eurozone is misguided. This is the consequence of using aggregate data to measure a variable that is only meaningful in physical terms. Indeed, aggregate unit labour costs are not just a weighted average of the firm’s unit labour costs. We have shown that aggregate unit labour costs can be interpreted as the product of the share of labour in output multiplied by the price deflator. The increase in aggregate unit labour costs observed across the Eurozone is the result of the increase in the second component, the deflator. In fact, except in Greece, labour shares have either remained stable since 1980, or declined. We have also argued that comparisons with Germany are also incorrect, as Germany’s export basket is significantly different. Wage reductions would do probably cause more damage through a compression of demand.
This paper represents the views of the authors and not those of the Asian Development Bank, its executive directors, or the member countries that they represent

References

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