Wage productivity gap again

I didn't show the figure below in my earlier post, because I really don't know how to import it and make it readable. But I believe it illustrates quite well the main ideas, so I do it now:

1. Wage-productivity gaps are observed in building construction and agriculture: reality or fiction (decreasing informality...)?

2- In any case, for manufactures, services and the economy as a whole (total), deviations are not significant

3 - Prices/ULC in services increased faster than in manufactures. The later are linked to PPP. The increase in the former explains the RER appreciation: once again, Pn/Pt is the issue , not wage productivity gaps.

To this, I could add a figure showing that on average wages in services are higher than in manufactures.

Thus, the challenge is to convince workers (and unemployed) to accept a lower pay while moving from services to manufactures.

The macroeconomic addjustment will be impaired not only by the economic climate, which is not investment-friendly, but also by any incentives unemployed may have to wait and see, rather than to accept an immediate move to a less friendly production environment.

Wage-productivity gap: where is it?

The problem with exports is not wages being too high in tradables. On the contrary, the evidence is that wages have evolved quite in shape with productivity, especially in manufactures. The problem is about to convince workers and unemployed to move from services, where wages are higher, to manufactures, where wages are lower.

INTRO

Competitiveness is a rather complex concept. In a broad sense, it refers to the extent to which a nation provides economic agents with (socially-aligned) incentives to produce and invest. For a moment, however, let’s focus on a narrow concept of competitiveness, related to wage costs. In particular, let’s stick with a definition proposed by Olivier Blanchard (2007), who refers to competitiveness as the inverse of unit labour cost (ULC) in tradable goods sectors relative to the corresponding world value.
In its influential paper, Blanchard (2007) argues that competitiveness in Portugal deteriorated significantly since the mid-nineties. According to the author, this reflected a misalignment between wages and productivity growth, which caused profitability in tradable goods sectors to shrink. However, Blanchard did not provide evidence supporting the claimed loss of competitiveness. The author showed that economy-wide ULC increased in Portugal faster than in the EU15, but he did not distinguished tradable goods (T) from non-tradable goods (N). The European Commission (2011) goes along with the same argument: “Since the introduction of the euro, Portugal has experienced significant real exchange rate (REER) appreciation vis-à-vis its trading partners, due to wage growth largely outstripping productivity advances (Graph 3)”. However, Graph 3 in the document only displays economy-wide real exchange rate indexes…
In a contrasting view, Campos e Cunha (2008) argues that “there is no room to claim a loss of competitiveness (...)” (p.158). The author points out that, in a small open economy, the real exchange rate and aggregate demand are two sides of the same coin. As it is well known, in a well functioning economy, an aggregate demand expansion translates into higher N-prices, while T-prices are bounded to remain unchanged. This causes a real exchange rate appreciation that has nothing to do with wage-productivity gaps. Fagan and Gaspar (2007) illustrate the argument is in the context of an endowment economy where, by definition, there is no such a thing as competitiveness.
Competitiveness and the real exchange rate do not necessarily go along.

FORMAL

To illustrate this, let’s look at the real exchange rate index based on nominal unit labour costs. By definition, ULC=W/a, where W refers to the compensation per employee (“nominal wage”) and a refers to Gross Value Added at constant prices per worker (“productivity”). Now, assume that the production function is a Cob-Douglas with labour-output elasticity equal to b and let Z be a variable measuring the wage-productivity gap: Z=ba/(W/P)=bP/ULC. When computed in terms of a base year (the constant b disappears) the index 1/Z is labelled Real Unit Labour Cost (RULC) or “real wage gap”. In a frictionless economy, Z=1. In a world with frictions, in face of a wage push, firms may opt to maintain a higher level of employment than that implied by the textbook wage-productivity rule. When this is so, the producer margin shrinks (Z<1).
Using the definitions above, the real exchange rate index based on nominal unit labour costs (RER-ULC) becomes ULC/ULC*=(P/P*)(Z*/Z). This means that RER-ULC accounts for two effects: wage-productivity misalignments (Z*/Z) and the increase in the relative price of non-tradable goods (P/P*). In a well functioning economy there are no wage-productivity misalignments, so Z=Z*=1. Still, unit labour costs may increase relative to abroad, whenever non-tradable good prices increase relative to abroad. This means that we can hardly rely on RER-ULC as an indicator of competitiveness. Competitiveness a la Blanchard is accounted for by the component (Z*/Z) and in the proportion corresponding to tradable goods, only.

EVIDENCE

Returning to Portugal, we now look at the data. In Table 1, se see that between 1995 and 2010 there was a

The state of the Union

Even before it began, Europe's moment as a major world power in the 21st century looks to be over. Richard Haass

The euro is in danger…If the euro fails, then Europe fails. If we succeed, Europe will be stronger. Angela Merkel

I think of the current state of the EMU as the result of three events. The first event is the political decision to adopt a common currency leaving EMU members without automatic mechanisms to adjust to external imbalances beyond self-equilibrating forces. The second event is the global financial crisis with her consequences including the recognition that large shocks are not an historical curiosity. The third event is the sudden comprehension by the financial markets of the first event.

The next figure partially summarizes the state of the EMU. The data are from the ECB and are used to set the stance of monetary policy.

Two sub-periods are evident: the pre-crisis and the post-crisis periods. The first 8 years show the performance of the ECB in controlling inflation ad stabilizing it around 2%: impressive. Equally impressing is the inflation oscillation that started in 2008 and is still unfolding. The EMU public debt to GDP ratio was stable at roughly 70% (10% more than the Maastricht rule) until the global financial crisis. The decline in output and the consequent worsening of public finances have now increased the debt to gdp ratio to almost 80%. Similarly the EMU public deficit has fluctuated around the -3% Maastricht limit until it ballooned during the crisis. Notably the EMU area has always had a fairly balanced current account and her actual net external position is small. The EMU growth has averaged 2.3% from 1999 to 2007 to later collapse and the EMU unemployment rate moved around 8.5%.

I see a picture of a sufficiently solid although static euro area that was hit by a large shock. There could be some concerns regarding the control of inflation (personally I am more worried by the downward trend of the inflation rate that excludes energy). The unemployment performance is unsatisfactory but this is not the picture of a collapsing economy. To observe the large imbalances that are threatening the euro we have to shift to a disaggregated picture.

The next figure depicts the state of the individual members of the EMU.

The heterogeneity within the euro is large in every dimension. Some states have very large debts, some have very large current account deficits, some have both and other have incredible unemployment rates for a modern democracy. The crisis has potentially put some of the weakest states in an unsustainable debt position exacerbated by large external imbalances. The heterogeneity per se is not a sufficient condition for questioning the existence of the euro area (and weights matter). For example the US states are very different in terms of employment, fiscal stance, size, productivity, ratings, etc (see here and here). The EMU has to design and adopt the minimum set of adjustment mechanisms that have to be present within a common currency area. There are many proposals that are discussed such as a common bond market and a larger fiscal integration. For the latter it could be interesting for europeans to know how much of the adjustment to the current shock is achieved in the US through automatic stabilizers such as unemployment benefits and how much is achieved through labor mobility (workers migration).

What is really necessary is for the EMU leaders to decide if they want to continue the integration of Europe (and how: a centralized state or the Europe of regions) or decide to go back to the now obsolete nation-state paradigm. A shadow is rising within Europe and it requires courage to dissipate it.

The euro and the Portuguese slump

   Can we blame the euro for the current economic crisis? Can we really be sure that we will never face the decision of having to leave the euro? Pedro and Rui seem skeptical about these possibilities. I will address these questions in more detail in forthcoming posts. Meanwhile, I would like to reiterate some ideas.
   First, do we have evidence that belonging to the euro played an important role for the current Portuguese slump? Absolutely. If we survey the literature and the existing empirical evidence (including work done by Fernando and his coauthors), it is hard not to attribute at least part of current ailments on the adjustment of the Portuguese economy to the euro.
   Second, is the euro really the main culprit for the “lost decade” in the early 2000s? Well, the jury is out on this matter. There are certainly data that support both positive and negative answers. Personally, I think that the data that suggest that the euro played a crucial role seem pretty compelling (I will survey these data shortly). Still, as I said, we must admit that some doubts remain.

The way out (2)

   An alternative to Pedro's provocative idea: dumping the euro. I know that economists are notorious in making predictions. Still, I think that it is pretty safe to assume that if the Portuguese economy does indeed have another "lost decade" (that is, if it remains stagnated for a prolonged period of time), it is very likely that in 10 years time we will be discussing how and when we will leave the euro. The country will not take another 10 years of low growth, high unemployment and high emigration (which, yes, is back big time) without politicians (and economists) starting to consider this heretic possibility. I know that leaving the euro is risky and costly, but I would not be surprised if this possibility becomes increasingly attractive if stagnation persists. (If it is not us, this is certainly a possibility for Italy or Greece).

Lessons from the Portuguese Stability and Growth Programme

After a long wait, we are finally getting to know some of the measures proposed by the Portuguese government to reduce the fiscal deficits. The strategy of the government is simple: tax, privatize, cut spending the least as they can, and expect the economy to recover. Will this strategy solve the structural imbalances of Portugal’s public sector? Likely not. Does that mean that Portugal will not be able to meet its target of reducing the budget deficit to 3% of GDP by 2013? It might, or not. It  depends, mostly on how the economy will behave. Still, it also might not matter, especially if the deficit is close enough to that limit (and if other European countries also struggle to meet the 3% limit). What the government seems be doing is trying to do is buying time. There are difficult decisions to be made, but the government is clearly opting not to take them. At least for now. Having said that, there are several lessons that we can draw from reading the latest Portuguese Stability and Growth Programme (SGP).  What are, then, these lessons?

 Lesson #1 _ Stay positive, stay the course

Right or wrong, the Portuguese government genuinely believes that the strategy of the last few years is bearing fruits, and that public spending and investment (both in the form of traditional public investment and public-private partnerships) will, sooner or later, stimulate the economy. More specifically, the government estimates that 36% of deficit reduction (about 2% of GDP) will come from the recovery of the economy. Is this reasonable? Probably yes. Between 2008 and 2009, tax revenues declined around 1,7% of GDP, while public expenditures increased around  2000 million due to the temporary rise in fiscal transfers related to the crisis. The government is thus assuming that by 2010, or 2011, tax revenues will be back to its pre-international crisis levels and that the temporary expenditures will cease to exist (a big assumption, mainly if stagnation persists).

Lesson #2 _ Increase taxes (but don’t tell the public)