As I ‘m sure is quite clear by now, I ‘m not a huge fan of the price mechanism as the main adjustment process for economic imbalances. In my view, most of the adjustment in the economy happens through quantities, especially for the (quite large) part that has high elasticity to demand (manufactured goods, services with the price mechanism working mainly in the case of commodities and housing). As a result, it is my belief that the current focus on ULC adjustments as a path for improved export performance in the periphery is wrong and will have negative results on final internal demand that will outweigh any possible positive effects on exports.
The correct way to look into this subject is to calculate export price and income elasticities. Nevertheless, since the ULC adjustment has only been happening since 2010, one can also use more ‘elementary’ tools to analyze periphery export performance for the last few years.
What I ‘ve done is the following:
- Use the goods exports price deflator to deflate intra-EU nominal exports of periphery countries. I am aware that this method might under/overestimate the relevant volume figures, but I ‘m not aware of any deflated series for intra-EU trade.
- Calculate ‘external’ intra-EU demand as EU-27 domestic demand in constant prices minus the corresponding periphery country figure.
- Take the ULC-based REER to EU-15. Although one should generally use a price-based index, I am using this index since the focus of internal devaluation is on wages and ULCs.
- Calculate correlations and R² for the 2009 – 2012 period for:
- exports and external demand
- exports and REER
- export prices and REER
- REER and internal demand
The results are not surprising:
- With the exception of Portugal, correlation between exports and external demand is close to 1 (with very high R²). This is in accordance with the literature that finds that, especially short-term, elasticities of demand are close to unity while price elasticities are much lower than one.
- Exports and REER show correlations close to -0.6 with low R². Greece is an outlier with a correlation of zero (which is a quite significant observation). In general, the relationship between ULC and export performance is weak.
- Correlations between export prices and REER are quite high with significant R². Yet they are of the wrong sign: A devaluation in ULC terms is accompanied by an increase in export prices. One should probably look into price effects more closely, breaking down export prices to import prices, nominal exchange rate (for import prices), profit margins and ULCs contributions, in the same manner that Ameco calculates the corresponding contributions for the final demand deflator. An interesting observation is that the correlation coefficient is quite similar for all countries.
- The correlation between the change in REER and internal demand is very high (close to unity for Spain and Portugal and 0.9 for the other two countries) with very high R². This means that any reduction in wages is automatically reflected on internal demand. Since the latter is far greater than exports, internal devaluation is self-defeating in real terms since it lowers a much larger part of demand. Imports are the only factor that cushions the effect somewhat.
Since periphery demand is a large part of external demand for most of the countries (22% for Greece, 16% for Spain, 12% for Italy), the combined effort to lower ULCs, along with the high correlation between REER and internal demand, actually also reduces external demand to a large extent. Given that the EU is in recession, it is only natural to observe an actual stagnation/reduction in exports, even though REERs have been reduced significantly.
Just to complement the post, I ‘d like to add the evolution of the Greek ULC-based REER towards the 35 main trading partners as well as of the NEER (a comparison I ran across on this paper). If the ‘loss of competitiveness’ of Greece was driven by ULCs, the ΔREER – ΔNEER should be large. A close inspection of the actual data shows that the contribution of ULC (in a trade-weighted analysis) actually trended around zero, with the NEER driving any changes in the REER (which appreciated around 17% between 2000 and 2009). It is quite strange to ask from workers to bear the cost of a nominal exchange rate appreciation through reduced wages and unemployment.