We’ll settle this internal devaluation question quicker than we thought

Unable to benefit from currency depreciation, the peripherals have been urged to seek other ways to improve their balance sheets by means such as ‘internal devaluation’ — regaining competitiveness by lowering costs, particularly wages.

One of the criticisms of “internal devaluation” is that it’s a slower method of improving competitiveness than an old fashioned currency devaluation. There are also questions about whether it even works.

Latvia and some of its neighbours, however, are examples of how it can work, as they managed to return to growth. But is their case really applicable to Greece and the other eurozone peripherals? Did Latvia, Bulgaria, Estonia and Lithuania return to such impressive growth anyway? Some – Krugman for example — think not.

In a Brookings Institution paper from earlier this year, Jay Shambaugh details some of the problems with internal devaluation. He writes that the decline in relative competitiveness of the peripheral countries happened gradually over the years since they joined the monetary union. For them to catch up now means reversing the increases in their costs — again, relative the rest of the eurozone.

This, however, is frustrated by the fact that core countries such as Germany managed to improved their competitiveness in large part because of the inflation going on in other parts of the eurozone. From Shambaugh’s paper:

Germany has gained only a modest amount against the euro area overall.34  Its principal gains are against the outliers.  This, in a sense, is the corollary of all the other results.  Internal devaluations tend to only be successful against the backdrop of higher inflation elsewhere. These results suggest that a rapid substantial shift in relative prices via wage or price compression is unlikely.  Some GIPSI countries have lost considerable cost competitiveness in the last decade.  Greek prices rose roughly 30% since 1999 relative to Germany (20% compared to the euro area ex-Germany).  Spain’s prices rose by 20% and 10% respectively.  To regain competitiveness at a rate of 5% over 3 years would require a decade of internal devaluation in Greece. Further, the three countries that have had internal devaluations in a low inflation setting (as well as the internal devaluation of Latvia, who is not in the data set) have tended to be in the midst of severe recession / depression.

Luckily, it might not take a whole decade find out whether this aspect of the current eurozone experiment can work — such that competitiveness can be regained by ailing countries without having to leave the currency area.

Société Générale points out that unit labour costs — basically, wages — have been falling quite rapidly in the peripherals, and that this is probably due to austerity measures. New data from Eurostat breaks out what the agency calls ‘non-business’ wages: the education, health services, and public administration sectors. In otherwords, ‘non-business’ is a rough proxy for the public sector:

The logical follow-on from the above being that “non-business” sectors are a big contributor to the rapidly falling unit labour costs in the periphery, especially given their large state sectors:

[NB - there was an error in the original chart showing a more dramatic decline from Greece, which has been corrected.]

SocGen’s Michel Martinez writes that there are outright wage declines in Greece while in the other peripherals, labour productivity (as measured by ULC) is outpacing wage gains. Hence:

This suggests that wage growth has come in line with sustainable productivity gains. The key conclusion is that erosion of ULC imbalances does not necessarily need to take a decade.

SocGen also see these peripheral movements in labour costs as helping keep eurozone core inflation in the 1.3 to 1.7 per cent range — creating optimal conditions for the ECB’s policies aimed at reviving growth in credit markets.

While it’s encouraging to see that economies can potentially right themselves in terms of unit labour costs, even in a currency union, some major questions about wider implications of declining wage growth sit on the sidelines. The effects on aggregate demand are sitting there looking at us with wide puppy dog eyes begging to be taken for a(n analytical) walk, for one. Something for another post, no doubt.

Related links:
Greek lessons from John Major, Latvia and Ireland – FT Alphaville
Bells in hell that don’t go ting-a-ling-a-ling – A Fistful of Euros