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.

1/6/2012: Gains in Competitiveness? Much done, yet even more to do

Much has been made of the fabled increases in Irish competitiveness in recent years. And to be honest, data does show some significant gains. But as this blog has pointed out repeatedly, these gains have not been (a) as straight forward as the Government would like us to believe, and (b) not a significant as to warrant the claims that we are one of the most competitive countries when it comes to labour productivity.

On (a) above, we know that most of the gains in Irish competitiveness during the crisis are accounted for by jobs destruction in heavily overheated construction and retail sectors. In other words, Irish average productivity improved because we pushed less productive workforce into emigration and unemployment, not because our more productive sectors increased their labour productivity.

On (b), here are the latest stats. All data is based on Harmonized Competitiveness indicators, unit labour costs, reported by the ECB. Latest data is through Q4 2011 and higher values reflect lower competitiveness.

Consider first the data for annual average readings:

Chart above suggests relative improvement in Ireland's position vis smaller member states of the euro area, but lack of significant gains compared to some groupings, especially those that combine more advanced economies in Europe. And chart below confirms the same:

Looking at the Q4 data - Irish competitiveness gains through 2011 have been far less impressive than annual averages suggest. Charts below show full sample of countries, followed by the EA12 euro area states excluding the 2004 Accession states.

Considered across the end-of-year figures, Irish unit labour costs remain well ahead of those in our closest competitors. Luxembourg - a country with virtually un-interpretable statistics due to huge imbalance between its workforce and population, as well as its economic output composition - is the only country of the old EA12 group that currently has lower labour competitiveness than Ireland.

What about pre-euro and euro-period changes? Chart below illustrates:

The introduction of the euro has resulted in deterioration in hci-based labour competitiveness metrics in all euro area economies, save for Austria, Finland and Germany. Largest deterioration took place in Slovakia and Estonia (catching up period, due to high entry differential), with Ireland posting third largest deterioration. The same remains even during the crisis period 2008-present, as illustrated in the chart below.

During the crisis, Irish hci-ulc index reading fell from 130.5 at the end of 2007 to 111.5 in Q4 2011 - the largest gain in competitiveness of all EA12 states. However, the rate of gains for Ireland has slowed down significantly in 2011. In 2009, the first year of improvements, competitiveness rose 7.1% on 2008, which was followed by a gain of 9.1% in 2010 and only 2.9% in 2011.