Today, Mr. Varoufakis posted a paper from Heiner Flassbeck on German Mercantilism which was presented in the recent INET conference. The paper’s basic statement is that, in a monetary union, countries agree on a common inflation rate which, in the case of Eurozone, was clearly stated as ECB’s target inflation rate of 2%. Since Unit Labor Costs are the main drivers of price increases, a logical conclusion would be that nominal ULCs should increase by a stable 2%, in order to compensate for increases in productivity and achieve the inflation target.
Unfortunately, if one compares ULCs for periphery countries with Germany the immediate result is that both did not follow the inflation target. Germany had a clear deflationary bias with labor compensation sometimes not even covering productivity increases, while periphery countries moved higher than the inflation target line introducing inflationary forces in their economies (and calling for a more tight monetary policy which is clear from calculating the ECB policy rate by using Taylor rule for periphery and core countries as per Fed, 2011):
A more detailed per country examination shows that:
- Ireland, especially after 2004, had a ULC curve which mostly resembled an asset bubble. It is quite clear that this divergence has been almost completely erased, at least compared to the inflation target.
- Spain also had a large increase but, as in Ireland’s case, has managed to reutrn back to the inflation target line.
- Portugal’s divergence was small and stable and was eliminated in 2010.
- Greece curve shows large movements with no stable pattern (apart from generally moving higher than the inflation line). A large part of the difference with the trendline can be attributed to 2002, when ULCs increased by 9,2%. While labor costs moved close to ‘equilibrium’ during 2006 – 2007, they gained momentum again in 2008 and the following years. Greece seems to be the only country in the group where ULCs have not adjusted after the 2008, although data is only available till 2010.
- Germany on the other hand managed to keep nominal ULCs basically constant and even negative (compared to 2000) during 2005 – 2008, creating a strong deflationary bias in its economy.
What is also interesting is to observe how ULC move in comparison with the increase in unemployment after the 2008 crisis:
It is evident that, while Ireland and Spain show a large adjustment due to unemployment (with high unemployment rates probably pushing wages lower), no such strong pattern is evident for Portugal and (especially) Greece. Developments during 2011 are an open question, although it seems that labor market in these countries have quite different characteristics.
One last note concerns productivity growth in the corresponding countries. Competitiveness (measured in our case by growth in ULCs) should not be confused with increase in productivity (which is a measure of real economic growth). This is evident by the following graph:
Although Germany was a clear winner in terms of ULC growth, it posted suboptimal productivity growth (the black line corresponds to a long-term productivity growth of 2% which is the usual trend in Real GDP growth for developed countries). On the other hand, Greece (which is accused of a substantial decline in competitiveness) posted an excellent growth, far above the 2% trend line, which only stopped in 2010. The same can be observed for Ireland as well (although at a smaller degree), while the Iberian countries posted low growth (the housing bubble does not seem to have helped Spain in this regard) and Italy barely moved since the Euro introduction. Since Italy does not face a private credit problem, it can be suggested that structural, productivity enhancing reforms, can have significant medium-term results and take her out of the current mess.