Some economists, and many policymakers, believe that wage cuts are needed to restore ‘competitiveness’. FT columnist Martin Sandbu writes “There are many problems with this view”, and proceeds to discuss three of them.
First, … it makes little sense to apply the concept of competitiveness to countries, which can’t go out of business, unlike companies, which can. National prosperity depends not on competitiveness but on productivity.
Second, the word competitiveness focuses our attention on tradeable sectors, as in “export competitiveness”. Non-tradeable goods and services, after all, do not compete internationally. … [D]uring the euro’s early boom years … cost increases were in non-tradeable sectors, and the deficits were racked up by import booms, not export erosion.
Third, competitiveness is often treated as measured by how low “unit labour costs” are — the total compensation paid to workers for a given quantity of production. But it is misleading to apply unit labour costs to whole economies rather than individual sectors. … [W]hat is the labour compensation involved in producing one unit of gross domestic product? It boils down to labour’s share of economic output. The theoretical abuse of applying the unit labour cost concept at the whole-economy level camouflages the capital-labour distributive conflict in the language of efficiency.
Martin Sandbu, “Free Lunch: Getting real about competitiveness“, Financial Times, 16 August 2016 (metered paywall).
Norwegian economist Martin Sandbu (born 1975) writes “Free Lunch”, an FT daily briefing on economic issues. He is author of Europe’s Orphan: The Future of the Euro and the Politics of Debt (Princeton University Press, 2015).
Sandbu draws freely from (and cites) a working paper written more than five years ago by Jesus Felipe and Utsav Kumar, two economists on the staff of the Asian Development Bank (Manila, Philippines). Here is the abstract and an ungated link to the paper.
Current discussions about the need to reduce unit labor costs (especially through a significant reduction in nominal wages) in some countries of the eurozone (in particular, Greece, Ireland, Italy, Portugal, and Spain) to exit the crisis may not be a panacea. First, historically, there is no relationship between the growth of unit labor costs and the growth of output. This is a well-established empirical result, known in the literature as Kaldor’s paradox. Second, construction of unit labor costs using aggregate data (standard practice) is potentially misleading. Unit labor costs calculated with aggregate data are not just a weighted average of the firms’ unit labor costs. Third, aggregate unit labor costs reflect the distribution of income between wages and profits. This has implications for aggregate demand that have been neglected. Of the 12 countries studied, the labor share increased in one (Greece), declined in nine, and remained constant in two. We speculate that this is the result of the nontradable sectors gaining share in the overall economy. Also, we construct a measure of competitiveness called unit capital costs as the ratio of the nominal profit rate to capital productivity. This has increased in all 12 countries. We conclude that a large reduction in nominal wages will not solve the problem that some countries of the eurozone face. If this is done, firms should also acknowledge that unit capital costs have increased significantly and thus also share the adjustment cost. Barring solutions such as an exit from the euro, the solution is to allow fiscal policy to play a larger role in the eurozone, and to make efforts to upgrade the export basket to improve competitiveness with more advanced countries. This is a long-term solution that will not be painless, but one that does not require a reduction in nominal wages. [Emphasis added.]
Jesus Felipe and Utsav Kumar, “Unit Labor Costs in the Eurozone: The Competitiveness Debate Again“, Levy Economics Institute Working Paper No. 651, Bard College (New York), February 2011.