Is Labor Productivity The Real European Problem?

Europe and US appear to be going through a patch in which all national problems are blamed on workers, at least by some politicians. It is curious that politicians and government leaders find that blaming the majority of voters for economic problems is a winning strategy, but such is the state of our public discourse. This does provide the benefit of turning the conversation away from the unpleasant prospect of stricter financial regulation, which would be immensely inconvenient to those financing many of said politicians, but one wonders at what point said majority of voters will tire of being the whipping boy? Yves Smith debunks the productivity argument in Naked Capitalism:

“Periphery” seems to be the new euphemism for the Countries Formerly Knows As PIIGS (which sometimes confusingly includes Belgium, since its finances aren’t so hot either).

The stereotype about these Whatever You Want to Call Them countries is that they are less productive than export powerhouse Germany, ergo they need to Work Harder and Accept Lower Wages (liberal use of capitals due to the force which which these pronouncements are typically made).

But this thinking does not stand up well to analysis, as a VoxEu post by Jesus Felipe and Utsav Kumar demonstrates. They contend that conventional wisdom relies on unit labor costs, which is a flawed metric:

….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….

…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….

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”.

So why do they think the periphery countries have become less competitive? It seems the real culprit is bad national economic strategy:

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.

Some have suggested that Germany companies might start outsourcing within Europe if wage differentials were higher, but there is no assurance this would happen on a sufficient scale if internal devaluations were the main adjustment remedy. There aren’t simple answers to any of these rebalancing needs, but more accurate diagnoses improve the odds of getting to better remedies.