A History of Failure: Restoring Competitiveness Through Wage Declines

Perhaps it is democracy's fault.

Perhaps national leaders in western countries simply think of their citizens as voters to be manipulated or subdued and have forgotten their other crucial role: consumers. If you have been in government most of your adult life and rarely have to pay for anything yourself because admirers or aides do it for you, you forget that is the common experience your people most widely share. And that much of your economy - most of your GDP - is based on those petty expenditures with which you rarely have to bother so you can think about more important things.

Because how else to explain the obsession with reducing the ability to spend without understanding the impact it will have on economic growth. A factor which appears to be manifest among otherwise seemingly sensible politicians in the US and Europe. Competitiveness with China or India? Dream on, dude. They will match you blow for blow in that sucker's game and will remain alone in the ring after you have been carted off by your bewildered supporters. There are numerous end-games to which the current austerity mania may lead. None of them are pretty. JL

The Economist reports:

Paul Krugman points us to Nouriel Roubini who argues that the history of internal devaluations—that is, restoring competitiveness through wage declines rather than exchange rate shifts—is mostly a history of failure. Reading this, it is difficult to be optimistic about Greece or Portugal: the way ahead probably paved with unemployment and economic decline. What's more, the political will to go through such a period in order to stay in the euro, retain the high connectedness to Europe and finally regain strength and grow, is of crucial importance. The Baltic states (Estonia, Latvia, Lithuania) probably have more of that than Portugal or Greece, and may have (as Ireland has) a flexible enough economy to get it over with quickly.

One should be careful with comparisons of countries, though. Small countries like Ireland or Latvia may not have benefited from a potential external devaluation as much as is commonly assumed. Iceland is a case in point (yes, once again). It made use of external devaluation, but it actually had to impose capital controls to limit the adjustment. What followed in a country that imports almost everything except fish and hot water is a temporary surge in inflation. Its real GDP performance, however, is very similar to that of Ireland or the Baltics; after adjusting by PPP, the real expenditures per person have fallen considerably and are still in decline (see chart, HT Jon Danielsson).

Why is Iceland not doing better? External devaluation minimises the economic costs associated with a slow adjustment to wages and prices. Unemployment will typically be lower amid such adjustments, and it has been lower in Iceland.

External adjustment cannot, however, solve problems with other, perhaps structural, causes—and sometimes it even exacerbates them. Take banking, or indebtedness of households and firms. The Icelandic banks are still, as far as Icelanders are concerned, far from being a healthy basis for the economy. Households are still struggling under the weight of inflation-indexed loans, and debts in foreign currency have increased in value with the result that firms are heavily indebted as well. Solving these issues is not trivial, and may prevent the other benefits of external adjustment from materialising.

Moreover, in the wake of the collapse of a large housing boom, the construction sector needs to shrink with all that entails in terms of structural change. Add to that two main export sectors that are capacity constrained (fish and aluminium), and you get a performance that is not as favourable as you might have expected from external adjustment.

Are there lessons for Europe? Again, comparing countries is difficult. Europe’s economies are large compared to Iceland or the Baltic countries. Their gains from external adjustment, relative to internal devaluation, would in all likelihood be much larger, and the costs smaller. There are differences within Europe, too. Ireland probably would not have gained as much from external adjustment as, for instance, Portugal, where wage reductions are apparently unconstitutional (?!) as Francesco Franco reports. Italy, on the other hand, may be constrained by factors other than the level of wages and prices.

What is clear, though, is that if adjustment must come internally, then the ECB needs to do everything in its powers to facilitate it. Unfortunately, there is no acknowledgement within Germany that the sub-2% inflation target, which is sending some countries into deflation, may be a problem.