Friday, September 27, 2013

27/9/2013: Internal Devaluation: Picking a Right Target?

Conventional wisdom of the 'internal devaluation' theory goes as follows: if a country like Ireland were to experience a structural shock, the path of adjusting to this shock lies via reduction in the cost of doing business (improving efficiency). Since adjusting the cost of Government or quangoes or Social Partners in the economy is an impossible task to undertake in a corporatist economy, then the only two things that can adjust to effect the 'internal devaluation' are capital costs (interest rates) and labour costs. In reality, however, capital costs are no longer responsive to interest rates since Ireland is in a major asset bubble bust and banking sector collapse. So we are left with deflating labour costs.

Aside from the knock-on effects such policies might have on aggregate demand and household investment, there is a nagging question of: can they be effective in reducing functional costs faced by businesses? In other words, are reduced labour costs associated with economic efficiency gains?

Logic suggests that even if successful, reductions in labour costs can only be as effective as labour costs' share in total output of the economy. How so? Suppose labour costs fall 10% and labour costs share in the economy is 50%, then, assuming freed resources are used somewhere more efficiently, the output boost can be substantial. If, however, labour costs are only 10% of the economy, then the impact will be smaller.

Now, here's a chart from the Robert Schuman Foundation research paper on Labour Costs and Crisis Management in the Eurozone:

According to this chart, Ireland was the second / third (to Greece and Italy) worst candidate in the euro area to implement internal devaluation policies along the lines of labour costs adjustments. And today Ireland is the second worst candidate (after Greece - the unlabelled purple line).

Yes, Ireland was the best candidate to apply these policies as the place with the worst labour costs competitiveness during the pre-crisis period.

But the adjustments, even though only partially successful, may be not impacting significant enough proportion of the economy to make much of the real difference.

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