It is fashionable to blame lack of competitiveness for having caused the Euro-crisis. Yet, competitiveness is difficult to measure. The most common indicator is relative unit labour costs (ULC), i.e. the cost of labour compensation, including taxes and social security, per unit of output. These costs are usually measured by an index that shows how much wage costs grow over time, but I will present here a more efficient indicator.
Unit labour costs will increase when nominal wages grow faster than labour productivity. Because labour costs are an important component of total costs and therefore of prices, policy-makers in the Euro Area have often stressed the Golden Rule whereby ULC should not increase faster than the ECB inflation target of 2 percent. This rule would also be distributionally neutral.
Figure 1 shows the evolution for member states in the Euro Area. It indicates that ULC remained below the ECB target (the red line) in four out of 11 member states, but because of the large weight of the German economy, the German underperformance has kept the Euro Area aggregate (thick blue line) below the ECB target. Thus, German wage restraint has helped the ECB to meet its inflation target, but at the same time it has enabled the South to ignore the Golden Rule and accumulate competitiveness losses. Especially Italy, Greece, Portugal and Spain have consistently overshot the 2% without any substantial correction before 2009. Only the financial crisis has changed wage setting habits – most dramatically in Ireland.
Figure 1
It is sometimes argued that a rebalancing of the Euro Area would require higher wages in Germany and even the German Finance Minister Schäuble has now rallied this argument. However, if wages are to increase faster in Germany, they will have to slow down in Europe’s south, or otherwise inflation will pick up and the ECB will tighten monetary policy. Hence, a coordinated approach to wage setting in the Euro Area should be part of the policies for avoiding excessive macroeconomic imbalances.
Nevertheless, cost indices as in Figure 1 are not a good measure for competitiveness, because they only show cumulative variations. They say nothing about differences in relative costs in the base year. Yet, it is less damaging for ULC to increase rapidly, if the economy starts from an undervalued position. To judge whether this is the case, one needs to establish a benchmark for relative unit labour cost levels and not of rates of change.
The rate of return on capital is such a benchmark. Ultimately, competitiveness is about capital being able to earn a decent return. If one takes the Euro Area as a benchmark, the relative return on capital in different member states would indicate whether labour costs are overvalued or undervalued relative to the average. Figure 2 shows the levels of equilibrium unit labour costs, calculated under the assumption that the return on capital in a given member state is equal to the Euro Area average (red line), and it compares them to the actual values (blue lines). We note that the equilibrium level of unit labour costs is neither constant nor necessarily close to parity (the horizontal line). The reason is that capital productivity has changed and/or inflation differentials have modified profit margins and these factors influence profitability.
Figure 2
Over the last two decades, persistent overvaluations of wage costs can be observed in Austria, Spain and Greece: actual unit labour costs are higher than the calculated ones. Undervaluations occurred in Belgium, Finland, Ireland, Italy, Luxemburg, Netherlands and Portugal. France and Germany are exceptions: France has moved from undervaluation to overvaluation and Germany did the opposite.
A quick way to see changes in the positions of competitiveness levels is by taking the difference between the actual and equilibrium unit labour costs relative to the Euro Area for a particular country. Figure 3 summarises this information into a single Competitive Index.[1] The zero line indicates that the average return on the capital stock in a given member state is equal to the Euro Area. An index number above the zero line represents an overvaluation. For example, 0.1 means that the ULCs of a member state are 10% above equilibrium. An increase in the index is equivalent to a loss of competitiveness.
The movements reveal the trends implicit in Figure 1. Remarkable changes have occurred: most dramatically in Ireland where the index rose from an undervaluation close to -30% in 2002 to -5% in 2007. In the Netherlands, it went from zero to -10% and in Germany from +10 to -5%. Greece has improved from +21% in 2000 to +7% in 2007, but this was not enough to eliminate the overvaluation. Italy has continually lost competitiveness from -11% to -2.5%, although it is still weakly competitive. The same is true for Portugal, where a correction started already in 2005, i.e. even before the financial crisis. Finland has reduced its advantage from -20 to -10%, and Spain has increased its disadvantage from 2% to 12%. France is also a sad story: the advantages achieved by competitive disinflation in the 1990s have been lost with a swing of 8 percentage points that has pushed the economy into overvaluation.
The competitiveness index presented here is a far more efficient tool for assessing the position of comparative advantages and relative competitiveness than the usual indicators used by the European Commission, the ECB or other authorities. It should be integrated into the Commission’s scoreboard of indicators regarding excessive macroeconomic imbalances that are intended to avoid future crises.
[1] The index was first published by CER Rapporto Europa 2011. See also my website: www.stefancollignon.eu
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This interpretion of competivenes is flawed. It only focuses on one aspect of a complex issue.
The most abused word in modern political economy is “competitiveness.” It is not just that each economist has a different definition, but even the same economist may define it in several ways, as Stefan Colliginon says. For most of them and for many institutions it is simply a description of short-term movements in wages. A more sophisticated definition is of short run movements in unit labour costs, but both are too often ideological, using easily available data to beat up workers and trade unions.
A good definition is “Competitiveness is understood to mean high and rising standards of living of a nation with the lowest possible level of involuntary unemployment on a sustainable basis.” But this does not inform on how to measure it.
I suggest the complexity of the issue is best understood by examining the work of Ireland’s tripartite National Competitiveness Council. It produces an annual Benchmarking or Scorecard report covering Ireland’s competitiveness performance in a comprehensive and coherent way. It has a collection of statistical indicators against a whole-of-economy comparison to 17 other economies and the OECD or EU average. Costs and labour costs are included but they are only a small part of the overall measurement of a country’s competitiveness. It is deeply disappointing that sophisticated analysts such as the OECD, IMF, the author etc. still define competitiveness only in terms of unit labour costs. But perhaps it is deliberately ideological?
Hi Paul
I am aware that there are attempts to define competitiveness by scoreboards and many factors and they are no doubt valuable (For example WEF and IMD). There is also a beautiful paper by Krugman about the non-sense of competitiveness obsession (Foreign Affairs, March/April 1994 (volume 73, number 2).
My point here is much more narrow: finding a benchmark for ULC levels. The indices, which are used by the Commission, ECB and also the Irish National Competitiveness Council, do not reflect the level effects and this can lead to distorting assessments.
Stefan