Catch-up effort required from lagging euro countries

Divergence of unit labour costs .....

A simple and frequently used indicator for a country’s competitive strength is its unit labour costs (ULC). Table 1 provides an overview. For all countries, the value in 1970 is set to 100. The divergence is remarkably high. In Germany, the ULC are a mere two and a half times higher than in 1970. In Austria and the Netherlands there is also a relatively limited rise. In Greece, however, the ULC increased by a factor eighty, while in Portugal they also increased relatively steeply.

Table 1 Unit labour costs

Source: OECD * 2010 data from Euostat

..... continued after the introduction of the euro

The 2010 ranking of countries according to the increase inUCLsince 1970 was almost identical to that in 1998. Still, more changes occurred in the EMU era (1998-2010) than appears at first sight. This becomes apparent when the ULC in 2010 are considered relative to the 1998 position (Figure 1)Firstly, it is remarkable that the extent of the divergence is far smaller than before, even if  an adjustment is made for the length of the period. Clearly, accession to EMU did indeed have a disciplinary effect. At the same time, it may be noted that in Germany, in the 1970-1998 period, ULC rose the least and that in the EMU era this is still the case. In southern European countries, ULC increased relatively the most before 1998 and this again holds true for the EMU era.

Devaluation no longer possible

In the pre-EMU era, countries were able to compensate their deteriorating price competitiveness by devaluating their national currencies. This way, high-inflation countries managed to prevent being priced out of the market. After the introduction of EMU this was no longer an option. At the introduction of the euro, insufficient guarantees and mechanisms were built in to prevent or adjust structural differences in price competitiveness. The continuing deterioration of the price competitiveness of countries such as Greece, Portugal, Spain and Italy has reduced the structural growth capacity of these countries to such an extent that investors have come to doubt whether the development of the government debt ratio would be sustainable. After all, one of the key factors in this respect is economic growth. The market’s waning confidence has led to higher interest rates for governments to be paid on government bonds of these countries, which further undermined their debt sustainability. This is one of the causes underlying the European debt crisis. 

Solution

Since the traditional adjustment mechanism (exchange rate adjustments) is no longer available to these euro countries, a different method must be found to restore their competitive strength. In order to reduce the ULC in southern European countries and consequently improve their price competitiveness, it is necessary to tear down the barriers that impede the necessary wage adjustments and labour productivity increases. Various reports, including the Global Competitiveness Index of the World Economic Forum, demonstrate that these countries still have a long way to go as far as labour and product market flexibility are concerned. For example, the ranking (from 1 for the best to 142 for the worst performing country) awarded by the World Economic Forum for the efficiency of the labour markets in southern European countries ranges from 119 for Spain to 126 for Greece. At the same time, one can point to the success stories in Germany, where between 2002 and 2005 the Harz reforms revitalised the labour market and strengthened the price competitiveness. In addition, the relatively high flexibility of the labour and product markets in Ireland ensured that this country’s price competitiveness improved substantially from 2008, making its growth prospects relatively favourable. 

An alternative option that is sometimes suggested is to raise the ULC in countries such as  Germany, the Netherlands, Austria and Finland. Yet, while this would also reduce the differences in competitive power among the euro countries, it would not be a good idea for various reasons. For one, it would diminish the pressure on countries with a poor price competitiveness to implement the required restructurings. In addition, the price competitiveness of the euro area in relation to countries outside the euro area would deteriorate. This could be countered by devaluing the euro, but the large disadvantage will be an increase in inflation for the entire euro area. In a group of pupils with mixed performances it does not make sense to have the good pupils perform less well just to reduce the difference in performance within the group. The best solution is to try and bring the lagging pupils up to standard and make them catch up without harming the results of the well-performing pupils. After all, not just the stragglers, but the good performers, too, will have to face competition from pupils of other schools once they have graduated. In the same manner, companies in for instance Germany or the Netherlands will have to face competition from companies in the United States, the United Kingdom and emerging markets.