Spiral Days

Spiral Days

Miguel Lebre de Freitas

The government announces that, from now on, and for saving purposes, the light at the end of the tunnel will be switched off. 

Intro

A main problem with large cross border capital flows is when they stop. During the up-phase, the excess demand over domestic supply translates into a selective inflation, whereby prices of non-tradable goods increase and workers acquire purchasing power over imported goods. During the down-phase, the reverse has to occur. In the case of Portugal, the fact that it belongs to a monetary union made many people (including me) trust that the down phase would be smooth. But in fact it wasn’t: after a long period of accumulation of external liabilities, private capital stopped flowing in abruptly, in the aftermath of the subprime crisis. True, the replacement of private capital by official lending allowed a smoother transition than otherwise. Still, the shortage of foreign capital broad sense forced the Portuguese economy into external balance in a very short period of time.

Looking behind, the adjustment process so far failed to deliver structural adjustment, in the sense that the labour force released by contracting industries moved to unemployment (and abroad), rather than being absorbed by export-oriented green field investment. Exports did increase, but this was largely achieved through a more intensive use of existing capacity. Some analysts interpreted this failure as a symptom of price and wage stickiness. This view fails however to account for the fact that, during most of the bailout period, external demand remained weak, access to credit was limited and - most important - Portugal faced one of the most serious confidence crises in its recent history. In such a context, lack of green field investment should not be a surprise. 
I take opportunity to argue that the tax hike on food service activities was a poor avenue to raise government revenues. 

The toy story

To make the point on VAT, I need a couple of graphs (don't worry: I just copied and pasted from my class-notes). This is a baby version of the dependent economy model without inter-temporal substitution effects and other complications. Figure 1 plots the country production possibilities frontier, domestic absorption and preferences (as implied by linear income expansion paths), splitting the economy into tradable (T) and non-tradable goods (N). In the Figure, take (P,C) as the situation at the outset of the adjustment process, with domestic absorption (A) exceeding the value of output (Y). In that stage, consumption occurs in C and production in P, and the horizontal distance between P and C measures the external imbalance (for simplicity, we start out with internal balance).

Then, consider the case where a major international portfolio rebalancing causes borrowing constraints to become binding to everyone in this economy, so that the aggregate is forced into external balance (one could discuss the case of a primary surplus, but that would not make much difference). In the figure, this is represented by a contraction of domestic absorption from A to A’.

Figure 1. External adjustment with sticky wages

The well functioning case 

In a well functioning economy, price flexibility would ensure that the relative price of tradable goods (lambda) increased. This would favour the macroeconomic adjustment, by inducing: 
(a) Households to switch consumption away from tradable goods towards non-tradable (the income expansion path would become steeper); 
(b) Firms to reallocate employment towards tradable goods. 
The new equilibrium would be reached at P’=C’, with internal and external balance. 

(Note that, since the value of domestic output in terms of tradable goods declines from Y to Y’, external debt as a percentage of GDP jumps up; in a World with financial market frictions, the implied balance sheet effect should weigh negatively on domestic absorption). 

The case with sticky prices

In the absence of an exchange rate mechanism, a capital flow reversal poses a major policy challenge: how to achieve the downward adjustment of wages and prices. If these fail to respond, economic recovery may become conditional on foreign inflation, implying a slow and painful adjustment process with high unemployment.

The case with nominal stickiness is described in Figure 1 by point S. In this case, nominal wages and non-tradable good prices fail to decline, so the slope of domestic absorption remains unchanged. Thus, production of tradable goods remains stuck in P, consumers remain attached to the original Engel curve and domestic absorption is required to fall much more in order to meet the external balance (A’’). In the new consumption point (S), the demand for non-tradable goods falls short the potential supply (P), so unemployment soars up, proportional to the distance between S and P. Employment fails to be absorbed by tradable good industries, because firms don’t see the relative price of tradable goods increasing. In the non-tradable goods sector, the employment contraction overshoots what is required in the long run.  

Point S illustrates the typical case of a “sudden stop” under fixed exchange rates and sticky prices. A popular example in this category is Chile at the time of the second oil shock, when generalized wage indexation prevented relative prices from changing. In the case of Portugal, there is also a view that the failure of wages and prices to decline is the fundamental explanation for the painful adjustment path along 2010-2013.

An alternative view 

Sticky prices is not the only possible explanation for the failure of export oriented investment and employment to spring up. Another candidate is the theory that entrepreneurs, perceiving an unusually risky environment, low external demand, and high borrowing costs, mostly decided to wait and see. On the financial side, highly leveraged banks with little margin of manoeuvre, found reasons to redirect the scarce loanable funds to the rolling over of debts of large borrowers banished from capital markets (including the government and SOEs), away from new entrepreneurship, which risk is more costly to assess. With low investment demand and low availability of credit, the production structure remained temporarily frozen, as determined by past investments minus current bankruptcies   

This case is described in Figure 2. Figure 2 is similar to Figure 1, except that firms refrain from hiring and investing, so inputs cannot actually move across sectors. Thus, the potential pattern of production remains unchanged, regardless of relative prices (in the figure, this is illustrated by the rotation of producer prices around P). 
The adjustment in this case is observationally similar to that in Figure 1: since employment in tradable goods does not expand, the external balance has to be meet somewhere in the vertical line below P in the direction of S. The actual short term equilibrium will depend on consumption prices: if consumer prices don’t change at all – like in Figure 1 – then external balance will be met at the very same point S; if consumer prices succeed in adjusting in the right direction, external balance will be met somewhere above S, in the direction of P: this will allow unemployment to be reduced, though not eliminated. 

Figure 2. External adjustment with unresponsive supply   

Fiscal revaluation 

In figure 2, I describe by point T the case in which consumer prices move in the wrong direction: from S to T, the relative price of tradable goods declines instead of increasing, causing the income expansion path to rotate further down, and the external balance to be met at a higher unemployment level (TP>SP). 
This case intends to capture the government decision of increasing the value added tax rate on food service activities: as this causes home good prices to increase in consumption, households are induced to switch expenditure further away from domestically produced goods towards foreign goods, causing unemployment to increase even more. Note that this effect also works in the case of Figure 1: irrespectively as to whether the unemployment problem was caused by price stickiness or investment freeze, the tax hike on restaurants acted as a fiscal revaluation on the consumer side, deepening the recession.  

Crowding out

Table 1 shows the IMF estimates of savings and investment as of June 2011, compared with the revised figures at the time of the 8th/9th review. These figures show that the external adjustment was much sharper than initially forecasted: in June 2011, the IMF estimated the current account to reach a deficit of €7.1bn in 2013, but the reality was a  €1.7bn surplus. Along 2011-2013, the cumulative difference amounted to €21.1bn. At the same time, government savings underperformed relative to the initial plan by some €11.4bn, cumulative (this figure does not include SOEs outside the budget perimeter). 
Of course, accounting identities tell us nothing about causality. But the broad idea that a sharper than expected contraction of foreign lending coupled with larger than expected government deficits translated into a huge crowding out of private consumption and investment should not be entirely out of reality.

Table 1: Gross savings and investment, 2011-2013, billion euros  

Source: IMF, Country report, June 2011 and 8th-9th reviews, Oct 2013. 

Spiral fear 

During most of the bailout period, Portuguese citizens shared a sentiment of fear about the future that naturally born out of severe austerity, but which political leaders and opinion-makers actually managed to feed, by discrediting the stabilization strategy. This includes most of the political sphere in Portugal, and - notably - the IMF, which looked like plagued with bipolar disorder. 
As for the general public, the message that the therapy could actually be killing the patient created a sentiment that the sacrifices imposed were useless. In a short period of time, the initial credential, consisting in a large political and social consensus around the MoU was eroded. In the media, the floor was opened for opinion makers and interest groups to show up and toll on discontentment, turning the policy design increasingly more challenging, each time a major initiative was ruled illegal by the Constitutional Court. 
Low social and political support, a narrow legal space and a track record of fiscal slippages amended by one-off measures, helped maintain a sentiment of exposure of taxpayers to the risks of extraordinary taxation, that obviously did not help investment and employment to recover. 

What now?

In the second half of 2013, there was an inflexion in the Portuguese people’ collective mood. This change followed the improvement in global conditions and had been already reflected in high frequency indicators before, but it was really when the media started echoing the first signs of recovery that the spiral word was banished from the opinion makers' lexicon. 
As for the future, the brighter economic environment will come along with renewed exporting opportunities, higher willingness on the part of entrepreneurs to invest and hopefully the easing of credit conditions. Eventually, constraints that were not the most binding in the stage before will show up, slowing down the adjustment process. Whether this will be price stubbornness, low competition, labour market mismatches, energy costs, or the continuing drainage of limited loanable funds by the government deficit,  I don't know. 
What we know is that the challenges ahead on the fiscal side are still immense: at the completion of the adjustment program, the fundamental question - “who is going to pay what?” - is still plenty of blank spots, urging answers of the permanent type. And yet, the prospects of recovery are coming along with a lower willingness on the part of citizens to accept more sacrifices. 

In this context, a political agreement involving the main political parties regarding the drivers and boundaries of the future fiscal strategy would certainly help. 
Until a scenario of fiscal stability becomes credible and perceived to be politically feasible by tax payers and bondholders, economic growth will keep facing strong headwinds. 

The real wage gap once again

Miguel Lebre de Freitas, 4-12-2013

Intro

It is amazing how wrong ideas can last for so long, just because they fit well in the narrative: it became vox pop that wages in Portugal have increased ahead of productivity, eroding external competitiveness, and that this caused the huge current account deficits that emerged in the decade before 2008. Fortunately, along the last couple of years, the profession has increasingly recognized the role of capital flows as the main drivers of external imbalances across the euro area. Still, the claim that wage-setting institutions in Portugal are naïve and eventually not prepared to live in a low inflation environment remains very popular in the opinion-making arena and is feeding speeches of radical euro-sceptics.

As I already argued here  (and here), the evidence does not conform well to the idea that the private sector in Portugal engages in crazy wage setting. However, my purpose at that time was to explain why economy-wide indexes of relative unit labour costs are poor measures of external competitiveness. In this post, I use the available data more intensively, to refute the claim that wages have increased above productivity. Actually, as for the last couple of years, the data suggests exactly the opposite: real wages look like having fallen below the productivity trend. This suggests that, if private investment is not responding at this moment, the reason should not be labour costs, but something else.

The variables used

Before starting, allow me a little remark: the following discussion presumes that the elasticity of substitution between labour and other inputs in the production function is equal to one. This is not a general case, but it works well with the historical data and it looks like working pretty well in the Portuguese case too - as we will see in a minute. But if you don’t buy this, please stop reading here.

Now, let me introduce the four variables we are going to play with. These are:

W - Nominal compensation per employee (euros);

V – Gross Value added at constant prices;

L – Employment (1000 persons);

P – Price deflator of Gross Value Added.

The raw data are from the European Commission, AMECO, backed by INE. The figure for 2012 has to be taken with caution, as it is based on an EC forecast that comes ahead of the INE’ official release.

The following sections explore different combinations of these four variables. We focus on two broad sectors that account for 80% of employment in Portugal: “Services” and “Manufactures”. It is worth distinguishing these two sectors, because they are differently exposed to international competition: manufactures consist on tradable goods only, while services include both tradable and non-tradable. Moreover, in the case of services, 1/3 of employment is accounted for by civil servants.

Angle 1: Real wages and productivity

We start with Figure 1. This figure compares the evolution of real wages (W/P) and of the average product of labour (V/L) in manufactures and in services, taking 1995 as the base year.

Figure 1:  GVA per person employed and Real compensation per employee (1995=100)

The first message in the figure is that productivity growth  has been much faster in manufactures than in services. This fact fits well in the story that large capital inflows, by inducing a reallocation of labour towards non-tradable goods, reduces a country’ exposure to the benefits of learning-by-doing, delivering lower growth and long-lasting effects. In the case of Portugal, this adds to a productivity growth in manufactures that does not stand out in international terms.  

The second message is that the indexes of real wages and of productivity have evolved mostly in parallel. Interesting enough, during the collapse of international trade in 2009, the productivity index in manufactures fell more than that of real wages, but in the years that followed the increase in real wages was smoothed downwards: it looks like inter-temporal trade between workers and firms is taking place, as an informal insurance against dismissals. In the case of services, the data in Figure 1 also points to a deceleration of real wages relative to productivity during the bailout period. 

Angle 2: Prices and Unit Labour Costs

Now, we use the very same variables to analyse the change in Unit Labour Costs, ULC=WL/V. In a world without frictions, one should have P=ULC/b, where b denotes for the elasticity of labour in the production function. In the case of tradable goods the output price is determined abroad, so the gaps between unit labour costs and prices can be taken as an index of external competitiveness (the famous Z in Blanchard).

In Figure 2, we compare the indexes of Unit Labour Costs and of Prices in manufactures and in services, using 1995 as the base year. 

The first fact in Figure 2 is that unit labour costs in each sector remained close to price developments. Just like in Figure 1, in the case of manufactures we see a significant jump in  ULC  ahead of prices in the year of 2009, but this move was immediately recovered. The figure also points to increasing producer’ margins in both sectors along the bailout period.

Figure 2:  Price deflators and Unit Labour Costs (1995=100)

The second fact in the figure is that, until 2008, prices increased much faster in Services than in Manufactures. This is the textbook response to a large capital inflow, as manufactures are exposed to international competition while many sectors in services are basically not. The figure thus illustrates quite clearly why the increase in economy-wide unit labour costs in Portugal relative to other countries has little to do with dysfunctional wage setting: unit labour costs increased wherever prices increased. In this particular episode, the real exchange rate measured with unit labour costs captures basically the increase in the relative price of non tradable goods, not wage productivity gaps.

Angle 3: Nominal wages and nominal productivity

Figure 3 turns to nominal wages. To stick with wages in euros (instead of using an index), we use a little trick: we simulate the marginal product of labour, by multiplying the average product of labour in nominal terms each year by the average share of labour in Gross Value Added along 1995-2010, which we take as proxy for b (that is, we compare W with bPV/L, presuming an unchanged b). The advantage of this procedure is that it takes as reference the entire period, rather than a base year, so we move forward, risking some measuring.

Figure 3: Nominal wages and the (simulated) marginal product of labour (ECU/Euro)

As shown in the figure, nominal wages increased in both sectors during the capital inflow episode. The stylized interpretation is that the expansion in the demand for labour in non-tradable goods sectors caused wages to increase in manufactures too. The fact that wages evolved almost proportionally in manufactures and in services along most of the period is suggestive of  cross-sector labour mobility.

The figure also reveals that, during the bailout period, nominal wages evolved in different directions in manufactures and in services. To a large extent, this reflects the cuts in government sector wages.

Turning to the wage gaps, as shown in Figure 3, departures of nominal wages away from the calibrated “labour demand” remained small along most of the period until 2008. In the case of manufactures, a significant positive wage gap emerged in 2009 (+4.6%). This was subsequently replaced by a negative one, that reached -4.6% in 2012. In the case of Services, gaps have also remained modest along most of the period, but a significant -4.3% emerged in 2012. Note that the negative wage gap in services cannot be accounted for by the cuts in public sector wages, because government wages and productivity are the same.

Angle 4 - Labour shares

Because the data on services above accounts for many sectors, including the government, it is worth  looking inside. Unfortunately, detailed data by INE is available until 2011 only.

In order not to repeat the three steps above, we focus on a summary variable, the labour share on gross value added, or – which is the same – the ratio between real wages and productivity (s=WL/PV). Without frictions, the labour share should be constant and equal to the elasticity of labour in the production function, b. The difference between these two, s/b (or 1/Z), is often labelled the “real wage gap”.

Table 1 displays the shares of labour in gross value added at the sectoral level (agriculture is excluded because the adjustment employment/employees produces odd results). The first column displays the shares on employment, as of 2010. The last column shows the average labour shares along 1995-2010.

As shown in the table, at the country level, the share of labour on domestic income has remained pretty stable around 67.3, reaching a maximum of 68.6 in 2005. With no question, this is too little to support the claim that wages have in general evolved ahead of productivity. In the case of manufactures in particular, the maximum observed labour share was  64.9 in 2009, which compares to the 61.9 average (hence, the +4.6% gap). In 2010, the gap in manufactures was already negative. 

In general, labour shares at the sectoral level are more or less trendless. There are however, some exceptions: on the up-side, "information and communication" stands out ("Building and construction" too, but we have reasons to suspect that the data for this sector, as well as for agriculture, is plagued by changes in the proportion of temporary labour or by changes in the level of informality); on the downside, sectors where the wage shares have been declining include "Transportation and storage", "Arts and entertainment" and – guess what –  energy supply. The industry of financial services also exhibited a declining labour share until 2008, but the productivity fall in the years that followed partially reverted the situation.  

Table 1 – Labour shares 

Summing up

1 – The claim that real wages have departed significantly above productivity does not match the national accounts data. In the case of manufactures, the maximum observed real wage gap amounted to 4.6%, during the 2009' collapse of international trade, to recover one year after.  

2 – In general the data supports the narrative that aggregate demand effects, rather than nominal wage stickiness explain the pre-2008 external imbalance: during the capital inflow episode, prices of non-tradable goods increased, pressing nominal wages up. This forced average productivity in manufactures to increase, in some cases with technological change, but mostly through the shutting down of low productivity firms, while labour was reallocated to low-productivity-growth non-tradable good sectors. 

3 – The preliminary data for the bailout episode suggests that real wages have been evolving below productivity, not the other way around. By 2011, this trend was more evident in transportation and storage, financial services, and energy supply. 

4 – The preliminary data for 2012 also points to the case that real wages in manufactures fell short the productivity trend by some 4.6%. This suggests a scope for entrepreneurs to raise profits by hiring more workers. However, there are reasons to believe that in the current juncture, other factors apart from labour costs are constraining the entrepreneurs’ choices. This will be the subject of my next post.