Do some countries in the Eurozone need an internal devaluation? A reassessment of what unit labour costs really mean

by Jesus Felipe and Utsav Kumar

Vox
March 31, 2011

The problem with Greece, Ireland, Italy, Portugal, and Spain is that they are uncompetitive and need to internally devalue – or so the argument goes. This column challenges this conclusion by pointing out that the measure used to back it up – unit labour costs – is flawed and misguided. Europe’s periphery lack of competitiveness is related to the types of products they export and not to the fact that their labour is expensive.

Along the periphery of Europe, there is supposedly a new crisis to add to the growing list, i.e. the crisis of “competitiveness”. Many analysts have concluded that workers in Greece, Ireland, Italy, Portugal, and Spain are too expensive compared with their far more efficient German competitors (Dadush and Stancil 2011). The argument seems to be that, in order to restore their competitiveness, these countries have just one option. Because they are all members of the euro, exchange-rate devaluation is out. For the same reason, monetary policy is out. And the monetary union has imposed fiscal rigidity, tying policymakers’ hands. That leaves only one route for adjustment: The labour market.

As a result, policy discussions are now focused on ways to lower unit labour costs. The drawback of this argument and discussion, however, is that the way unit labour costs have been calculated to reach the conclusion above is problematic. Unit labour costs are defined as the ratio of the nominal wage rate (in euros per worker) to labour productivity (in units of output per worker, e.g., number of automobiles produced per worker). The units are, therefore, euros per automobile. But this is not the way the unit labour costs that are being discussed are calculated.

In a new paper (Felipe and Kumar 2011), we discuss a number of problems with the recent work on unit labour costs in the Eurozone and the policy recommendations derived from it. We discuss four issues. The first two are conceptual. The third one refers to the comparison with Germany. And the last one is a comment on the empirical relationship between unit labour costs and growth. Europe’s peripheral countries are in trouble but the problem and solutions are unrelated to their aggregate unit labour costs.

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