Competitiveness and Recovery

David Begg criticises the ‘deflationary’ strategy in an article in today’s Irish Times (you can read it here). In reading this article, it is helpful to remember that the term deflation requires subtle interpretation for a member of a monetary union. In particular, the main substantive issue is whether real devaluation is a necessary part of a recovery strategy, where real devaluation means a decline in relative wages and prices in Ireland relative to our trading partners. For a low-inflation monetary union, an individual member country may require a temporary period of deflation in order to attain a significant real devaluation.

David Begg argues that there is little evidence that deflation facilitates recovery. However, there is a strong body of evidence that real devaluation is helpful. Just taking Irish economic history, the devaluations of 1986 and 1993 were contributory factors to economic growth.

It is certainly true that the global recession means that the level of external demand is low. It is also true that the re-orientation of spending in the world economy towards Asia and away from the United States does not help Ireland, given the nature of trading patterns.  However, these external factors simply underline the scale of the negative shock that Ireland is enduring.

It is also true that high levels of household debt means that deflation carries an extra cost in terms of raising the real burden of debt repayments. However, the single biggest risk factor in debt repayment is unemployment and a strategy that minimises the growth in unemployment through the restoration of competitiveness dominates.

The real question is whether there is a credible alternative.  If Ireland had run a counter-cyclical fiscal policy during the good years, there may have been room to do more in terms of counter-cyclical fiscal expansion now. However, the scale of the fiscal deficits and the fragile state of international bond markets mean that significant fiscal expansion cannot be entertained.

Rather, the focus has to be on restoring international competitiveness through real devaluation (plus other measures to fight monopoly power in the economy and improve productivity).  This will stimulate not only the export sector but also the domestic nontraded sector, since the level of domestic consumption will be boosted if Ireland can establish a sustainable growth path.  In relation to the export sector, the gain will not only be in terms of the performance of existing sectors and firms but also in relation to the ‘extensive margin’ (new firms exporting for the  first time, sectors emerging as internationally competitive).  In turn, suppliers of domestic services to these firms will gain, such that the employment impact will be wider than just the export sector itself.

39 thoughts on “Competitiveness and Recovery”

  1. It is clear that real devaluation is necessary to restore competitiveness. However I’m somewhat confused as to how this will stimulate the domestic non traded sector?Surely this real devaluation partly caused by wage cuts will lead to reduced domestic demand?Or is the main thrust of the argument saying that real devaluation will put us onto a sustainable growth path and the domestic economy will then be stimulated as a result of this growth?

  2. Commercial rent is a factor in competitiveness. NAMA will try to maximise recoveries. Is there a little confict of goals here?

  3. It isn’t helpful to lump fiscal consolidation and wage cuts together, as David Begg does, under one ‘deflationary’ heading. They are analytically distinct.

    Will fiscal consolidation help in ensuring fiscal sustainability? Of course. Will it help the real economy grow? No: on its own, it will have the opposite effect.

    To hit two targets you need two policy instruments. We have a fiscal crisis and a real economic crisis. To minimise unemployment, we therefore need a real devaluation, as Philip says. If we were not in EMU I would be calling for a nominal devaluation, but we are in EMU, and devaluation is out for a host of well-understood reasons. Hence, we are left with wage cuts.

    As an aside, public sector wage cuts are a substitute for the cuts which the McCarthy report recommended. Any of those specific cuts should be evaluated against several alternatives, one of which is lowering the cost of providing existing services by cutting wages.

    @Ahura: to be sure, if NAMA were to put a floor under the required downward adjustment in property prices of all sorts, that would be bad for the economy as well as the taxpayer. Good point.

  4. There is another blog running on David Begg’s piece: it’s on theIrish Times website. Generally the comments are fiercely critical, and in my opinion well-argued. Begg’s quoting of Joe Stiglitz’s comments on the US fiscal stimulus in support of his (Begg’s) critique of Irish fiscal policy is quite ridiculous.

  5. I expect David Begg would have no problem with unjust profits and waste being removed from the system to improve competitiveness.

    I think it is inevitable that the laws will change to require more transpareny in a whole range of areas to avoid unjustified profit taking and leakage of profits.

    If we can identify where huge profits are being taken then the market (new competition + customers) and political pressure will react to eliminate the unjustifiable element of such profits. If the entry costs are too high then the State will subsidise new entrants or, where incumbents have benefitted from the State, oblige incumbents to facilitate entry by others.

    I also think we need transparency on wages and remuneration in banks, utility companies and other monopolies.

    The age of privacy is coming to an end and no wardrobe without a red bandana is complete.

  6. Goodbody chief economist Dermot O’Leary said this morning that Daft.ie currently have 57,000 second-hand houses for sale, equivalent to 19 months supply at current rates.

    The US National Association of Realtors said last week that total s/h housing inventory at the end of June fell 0.7 percent to 3.82 million existing homes available for sale, which represents a 9.4-month supply at the current sales pace, down from a 9.8-month supply in May. Raw inventory totals are 14.9 percent below a year ago.

    So reality has to yet hit the Irish housing market as it has to on the wages front.

    The average pay of a TD is at a similar level to a US Senator and so on.

    Like the house prices, the comparisons make Ireland look ridiculous.

    Data for earnings by occupation in Denver:
    http://www.bls.gov/oes/2008/may/oes_19740.htm#b00-0000

    A-Z metro areas:
    http://www.bls.gov/oes/current/oessrcma.htm

  7. The distributional effects of a real devaluation achieved through public non-pay reductions and private sector pay cuts need to be debated in more depth. Philip acknowledges the potential problems that might be created in terms of increases in real value of personal debt. We dont have figures but the main brunt of this, I would suggest, come on young recent buyers who are more likely to have children. This has a host of potential effects on work incentives as well as intergenerational effects that have not been discussed widely.

  8. Competitiveness, devaluation, restructuring. Let’s be honest, the apostles of the dismal science are proving beyond doubt why they are so labelled. These weasel words are not the impartial sound bites of disinterested academic scholarship. They have become metaphors for an intellectual ascetism that casts its shadow over the Irish economy. When economists champion the imperative of cuts in living standards, they also demonstrate an appalling failure of imagination.

    David Begg’s naive challenge to the McCarthyite orthodoxy of privation unfortunately suffers from their same blinkered perspective on the recession. The notion that we can spend our way out of recession is only as stupid as the notion that we can stare ourselves out of it. What both the pessimists and optimists share is a common delusion that spending is the engine of an economy. What both sides ignore is production.

    Ireland’s phantom growth of the Noughties was based on borrowing from the international markets. This huge expansion of credit fuelled the property bubble, swelled the retail sector, misallocated capital into unproductive bricks and mortar and indebted Irish households, businesses and the banking sector. The reality is that the real economy has been living off the fruits of economic dynamism in the Nineties and massive borrowing from overseas.

    The Irish economy will not escape from the painful effects of deleveraging and economic atrophy until the Irish poilitical class (inlcuding their disinterested scholars) start to grapple with restructuring the private and public sector to expand productive activity, promote value creation and improve productivity. This requires ambition and a commitment to sink capital into the real economy.

    Steve blogs here

  9. What facilitiates recovery (let’s say helps correct excess supply in goods and labour markets in particular) is price flexibility.

    Unfortunately our prices are now predominantly measured vis a vis the Euro area constituents at a constant currency.

    What exactly does Begg want to do? Hold back the tide????

  10. @Adam, employment in the domestically traded services sector seems to track total employment in the Irish economy closely. Or at least it has done so as far back as I have looked, which is to 1998. So, if this holds up, more jobs in internationally traded industries means more jobs in domestically traded services, more taxes to put a dent in the public deficit, and construction employment eventually stabilising at a higher level than would otherwise be the case.

  11. David Begg is using the word stimulus in a marginal sense rather than from a nominal perspective – we’re already running an 11% or so deficit this year (ie a stimulus is already in place!), we’re gonna go with 10% next year, and we’ve been running a large structural deficit for the last 5 or 6 years.

    His rational is that we need to do more to boost the economy (via public sector expenditure) regardless of the actual level of either public sector expenditure or the government fiscal deficit. In theory there may be some, and i stress some, merit to his argument, but in practice there’s absolutely none. We simply can’t borrow any more.

    It smacks of a fat spoilt kid demanding more sweets from their parents, even though they’ve just gorged on a big bag of them for the last decade. David Begg seems like the type of parent who would keep feeding the kid just to shut him up for another 5 mins. He completely misses the rather obvious argument that its been this type of behaviour over the last decade that has helped get us into the terrible position we now find ourselves in. I really fear for the social partnership discussions going forward if this is the best that the Unions’ chief economist is capable of.

    Btw, did anyone notice that there’s not one actual counter suggestion to the governments deflationary policies from Begg? He doesn’t agree with the current policies, but offers no alternatives in return (other than ‘borrow more’!). Why exactly are we even listening to these people?

  12. The argument that wage cuts will aid ‘competitiveness’ would be helped if it was fact-based. For instance, Destatis (German Statistical Board) shows that, in 2008 4th quarter) Ireland’s manufacturing labour costs ranked 10th in the EU-15 – over 2% below average. And the only reason we rank ahead of the UK is because wages (in Euros) fell over 9% due to sterling depreciation, not a reduction in their cost base. When Irish manufacturing labour costs are compared with our peer group – the top-10 economies in the EU-15 – we fall behind the average by over 16%. The relatively low labour costs here are confirmed by the OECD (Benefits and Wages database) and the US Bureau of Labor Statitistics.

    Cutting wages to boost our export sector would make little difference. Using the CSO’s prelimnary estimates for 2007, wages in key manufacturing sectors (Food, Chem/Pharm, Optical/Electrical – which make up 54% of employment and 70% of gross value added) make up between 6-8% of total costs. What would the effect of a 5% cut in wages be? It would reduce the cost base in these sectors beween 0.3 and 0.4%. Is it really being argued that this would ‘boost’ our cometitiveness – especially when you factor in the hit that domestic demand and the Excehquer would take with such a wage increase? Maye thats why the Industrial Relations News reports that all Chem/Pharm companies have paid the first tranche of the wage agreement, despite IBEC’s withdrawal – because it makes no difference.

    In the non-traded domestic sector, Forfas did a useful survey of the costs of running retail enterprises. They benchmarked Irish cities with UK cities but there are problems with this because of the sterling depreciation. The one other Eurozone city they surveyed was Maastricht. Unsurprisingly, it’s cheaper to run retail enterprises in Maastricht but it had absolutely nothing to do with wages. In fact, wages here are much lower here (14% lower for sales assistants, 35% lower for customer service representatives). The difference in costs were commercial rents (6 times higher here), telephone, IT services, etc. If anything, our low wages closed the cost gap – not widened it.

    I fear that we may end up all day and night cutting wages and still wake up the next morning and still have the same competitivness problems – because we were looking in the wrong place. And consumer spending would be lower while unemployment would be higher. A high price to pay for an unverified assumption. It would be helpful if the Government asked the relevant agencies to do an in-depth sectoral survey of all costs – not just wages – much as Forfas has done with Retail and the Print/Publishing sectors (which also showed Irish wages well below average). This would be extremely informative. Until then, we have to use the data that is available – and that data suggests only one thing: Irish wages aren’t the problem.

  13. Michael Taft is using ‘partial equilibrium’ reasoning. If wages decline on an economy-wide basis, the traded sector will expand through a variety of mechanisms. First, lower labour costs will translate into lower intermediate input costs (it is not just the labour cost in the exporting firms that matters). Second, it is important to look beyond the set of already-exporting firms. A decline in labour costs will facilitate the conversion of non-exporting firms to exporting status and the entry and growth of new firms. The relevant empirical evidence is the impact of real devaluation on economic performance which is a macroeconomic question and looking at the labour costs of only already-exporting firms is not the right basis to assess the argument. The gain in employment will not just be confined to the traded sector, in view of the complementarity between outputs in traded and nontraded sectors.

    Joe Stiglitz was a big advocate of real devaluation during the Asia crisis; Paul Krugman has also stated it is the only route open to Ireland.

  14. @Michael
    “Unsurprisingly, it’s cheaper to run retail enterprises in Maastricht but it had absolutely nothing to do with wages. In fact, wages here are much lower here (14% lower for sales assistants, 35% lower for customer service representatives). The difference in costs were commercial rents (6 times higher here), telephone, IT services, etc. If anything, our low wages closed the cost gap – not widened it.”

    We’re back to rents and property prices. I have worked in retail since 1991 as an accountant, I know the costs. Between 1993 and 2006 (when I went out on my own) the cost to rent a 30,000 sq ft retail warehouse went up over 400%. (This ignores service charges and the original spec of the building which have also changed hugely) Rent was the second biggest expense after payroll for the businesses I was involved in. Rates went up accordingly as the rate is directly tied into the rent paid. You’d have thought our county councils should be rolling in money.

    On the payroll side in about 10 years the costs more or less doubled.

    The problem is there is no mechanism to reduce rents – upward only rent reviews – so the retailers have to attack other costs and the obvious one is payroll if you want big savings.

    The conclusion must be rents need to come down – based on the history by at least half. Of course that will reduce the valuations of the property portfolios and empty retail buildings which would impact on NAMA! But economics is about supply and demand. Rents with upward only rent reviews is a distortion of the market as it removes one of the major mechanisms to rebalance costs.

  15. Just because its cheaper to employ someone doesn’t mean increased trade and associated jobs creation will automatically follow – the missing bit is new enterprise creation – privation is necessary to pay for past excess – investment is required to create sustainable export led enterprises. Where will the new jobs come from?

  16. Philip – just to note that in our main export platforms, companies do not source that much from Ireland (approximately a third). If the impact on the cost structure of the supplying firm is inputted into the exporting firm the effect would still be minimal. Concerning the conversion of non-exporting firms to exporting status – Forfas, Enterprise Ireland, Ahead of the Curve, Catching the Wave (going back through Culliton, Telesis and beyond) have all identified the entrenched structural and even cultural problems in our indigenous base of which a few are: Scale, personnel for internationalisation, working capital to finance exports, information (including cost) to locate/analyse markets, identifying export opportunities, managerial time to deal with internationalisation, contacting potential overseas customers, R&D and in-house training, developing new products for foreign markets, foreign business practices, export product quality/standards/specifications, exporting procedures/paperwork, etc. These have little if anything to do with wage-competitiveness and, indeed, low wages may act as a disincentive in attracting the skills needed to upgrade our indigenous base and convert them to export markets.

    In this vein, it might be worth reading FAS’s Assessment of the Management Skills of SME’s (they contracted management consultants to carry out the survey). Not only does it make disillusioning reading, it is clear that cutting wages by whatever amount won’t help these companies (http://www.skillsireland.ie/media/egfsn060512_sme_development.pdf )

    Since the mid-90s the general failure to convert our indigenous base to export practice is hard to explain in the context of low business taxes, including payroll, relatively low-wages (much lower in 2000 but still low today), a light regulatory regime and employer-friendly labour practices (e.g. the lack of the right to collective bargaining). Hard to explain unless we focus on the real problems in our enterprise base.

    I’m willing to accept that it may not be right to analyse already-exporting firms if you could lead me to the verifiable data with which to properly benchmark the impact of wages. So I still have to ask the question: given all the endemic structural problems we suffer from and the fact that our wages fall well behind our peer group – how can reducing the cost base marginally help firms? Can 0.5% make all that difference?

    By the way, do you agree that an in-depth sectoral survey of all cost inputs – of the type that Forfas conducted in the retail and print/publishing sectors – would be helpful in this debate?

  17. I continue to be a mazed about the people talking about wage and price adjustment in Ireland in a normative context (including some well credentialled academics here).

  18. Eoin,

    You ask: “Why exactly are we even listening to these people?”

    The answer: because they are part of the establishment, the third leg on the ‘social partnership’ stool, along with government and the employers.

    The fact is that for most of the past ten years social partnership on the trade union side has been mainly about increases in public service pay and public service numbers and expansion of social services. This article by Begg is yet another example of their lack of capacity to deal with the crisis facing our economy, to think along any other lines outside the traditional mould that they’ve become accustomed to.

    I don’t doubt the good intentions of David Begg. Nor do I think he is misguided in his earnest desire to protect the more vulnerable sectors of our society in this crisis. But he and the rest of the trade union leadership are giving a good impression these days of being lost in a fog and having no idea of which direction they should turn in next. It’s obvious that there’s a show down coming with the government and employers on some of the more arcane mechanisms for determining sectoral wage rates, and specifically with the government on public service reform and the McCarthy report recommendations – the final bust up of ‘social partnership’. But I think there is a very real fear that, as happened with the ballot for a national day of strike action, they will not be able to carry their members with them if they threaten industrial action to oppose government action.

    Personally, I think Begg’s article in the IT is one of the worst pieces of economic analysis I have ever read.

  19. @Michael, I have lot to say on this, but other work to do, so I’ll limit myself to one point for now.

    A large part of the reason why our indigenous base failed to improve its exporting capacity since 2000 is that the opportunities in Ireland have been irresistable. The talent that should have been building Ireland’s export base has been engaged in property development, construction, building businesses in indigenously traded sectors that offered vast excess profits, and piling into the fast-expanding and well paid healthcare professions. For better or worse, exporting looks more attractive now.

  20. @Michael Taft

    Michael,

    Wages are only one factor in competitiveness and in late 2007, the World Bank said Ireland was among the four most expensive economies in the world.

    The corrupt land rezoning system, poor planning, professional services protected by restrictive practices and high stealth taxes all feed into high costs

    As regards wages/salaries, not all workers are earning good wages but the lower paid, without occupational pensions, are generally in the private sector.

    According to the CSO, workers in the electricity and gas sectors, earn double the weekly industrial wage.

    The Celtic Tiger came and went and we remain dependent on a small number of American firms for most of our exports.

    Total hourly compensation for an average American manufacturing worker was $30.56 in 2007. In Denmark, the hourly rate was 56 percent higher than in the United States (at $47.54); in Germany, it was 66 percent higher ($50.73), and in Norway it was 80 percent higher ($55.03). In Ireland the rate was $35.62. For 19 European countries, the average, which includes $7.69 per hour in Poland, was $9 per hour higher than in the United States.

    Excluding social security add-ons, the German hourly wage was $9.9 compared with the Irish rate of $15.9

    In Japan, the average hourly compensation for a manufacturing employee in 2007 was $23.95, or 80 percent of the average American.

    Not so in Mexico. The hourly compensation there was $3.91, or 12 percent of the average American hourly rate. But that’s not even close to China, where it was $0.81 per hour, or 2.7 percent of the rate in the United States. Compensation includes all pay, employer social insurance expenditures and labour taxes.

    http://www.bls.gov/news.release/pdf/ichcc.pdf

    World Bank study:
    http://www.finfacts.ie/irishfinancenews/article_1012158.shtml

    For indigenous exporters, who are dependent on the UK for about 50% of the demand, currency is a factor.

    Within the Eurozone, in the biggest market, in the area of Irish strength, food and drink, selling to the likes of Aldi and Lidl in their home markets, is a challenge that may not be even be met with big wage cuts.

    However, to have a chance, Ireland has in business terms no option but to reduce it costs of operation – – be it in whatever sector – – in public and private.

  21. Michael, thanks for these links. I fully agree with much of your analysis of the cost implications of property and land policies (and, in particular your work on Finfacts regarding the Government’s misleading treatment of exports). There is no doubting the need to reduce costs. All I’m suggesting is that we analyse all factors in a consistent and verifiable way. I note that the BLS stats you link to show that Irish wages are below the average of other EU-15 countries (production workers are more than 6% below in US$). When we compare ourselves to our peer group – we fall behind even further. Just a question – you cite figures that, when xcluding social security add-ons, show Ireland ahead of Germany. Are you sure you’re not citing figures that relate to 2006-2007 percentage wage growth in Table A? Please correct me if I’m wrong.

    Veronica – I’ve been called many things but never ‘part of the establishment’. As I work in UNITE and, prior to the merger, ATGWU, I doubt that the label would be considered accurate by anyone. But, then, that’s the problem with labels. Best to stick with the argument.

  22. Michael,

    I wouldn’t dream of calling you anything, never mind part of the establishment!

    If you read my post again, it should be clear: I was referring to Social Partnership; of which the three principal elements are employers, the trade unions and the government, and which is undeniably part of the establishment of the Irish State.

  23. Veronica – I take that and apologise for taking you up wrong. Though I would suggest that members of the union I work for (and worked for) would be amused to be called ‘part of the establishment’. If we actually were, it would be a much, much different establishment.

  24. I would say that all of the commentators here with the exception of Michael were at the Patrick Mc Gill Summer School last week !!! Poor Mr Beggs must have been very lonely there. He would have had Minister Coughlan there to soothe his nerves about continuing Social Partnership. What a joke that is when the majority of the population are not represented but those with beards are ……..

  25. @Daithi

    It would be useful if economic commentators stopped trying to discover bitter pills or golden geese to rescue our lack of competitiveness and started examining the anaemic character of the private sector. Michael Hennigan, Michael Taft and Ronnie O’Toole have all in their own way tried to broaden the discussion of the economy to address either structural or political problems in the economy. It would be useful if there were more critical discussion of the backward character of Ireland’s bloated indigenous private sector (tourism, retail and construction).

    It is clear that the private sector is too dishevelled to afford the public sector expenditure, but surely that maens we should focus on how to invigorate value creation. The longer the debate is confined to miserabilists championing haircuts and naifs promoting more borrowing, the longer it will take for the pain of recession to recede.

  26. Deflation is here. Its real. It will cause significant, and serious, economic, financial and political problems. The wealthy will experience a loss of their wealth: the poor will be lucky if they are not crushed by poverty. We could slow, but not prevent, this reduction in our standard of life with a Debt Jubilee.

    The debt burden is too high to pay down. Future incomes will not suffice. Voluntary default or imposed bankruptcy – which do you want?

    The growth that many of you seek will not appear. The ‘fundamentals’ are stacked against us (the Permagrowth economies).

    The trades union are not part of The Establishment?? Since when? No matter. Hunger and poverty do not distinguish between left, right or centre.

    Brian P

  27. There has been a good discussion in this thread. For lack of time, I will only respond to a few points.

    1. At a macroeconomic level, labour costs are a very large part of the overall cost base of the economy: the share of labour costs in economy-wide value added is high for all advanced economies (it is a bit diluted for Ireland due to the impact of the high-profit pharma sector). Accordingly, there would be a ‘wave’ effect from a widespread reduction in wages, showing up directly but also indirectly via the embedded contribution of wages to domestic input costs.

    2. In looking to the future, the main expansion in the tradables sector needs to be in labour-intensive sectors (high-skilled business services) – the employment gain from these sectors will necessarily be larger than the large pharma/hi-tech operations for which the labour input is relatively limited.

    3. In advocating real devaluation, this is not to deny that the economy faces severe problems in improving productivity across the economy. However, I consider it to be non-controversial to be in favour of higher productivity, so I have focused on the issue in dispute which is labour costs. The correct strategy is to work on both fronts – cost reduction and productivity enhancement. The incentive effects for workers to upskill are pretty powerful at the moment, given the level of unemployment, and a recovery path can promise wage increases in the future in line with economic performance.

    4. I note that there is an interaction between the competitiveness debate and the resolution of the banking crisis. Access to finance is an important contributor to the decision to begin exporting.

    5. There is certainly a normative component to the debate about wages and prices, in view of the important role of policy in determining factor prices. Most obviously, the wage level in the public sector is determined by policy but legal factors mean that wages in many private occupations are also influenced by policy decisions.

    6. As noted in the discussion, one result of the bubble was the diversion of a lot of talent into the property sector, domestic finance and other domestically-orientated activities. With the change in the economy, there may be a much greater pool of talent now available to export-orientated firms.

  28. @ Michael Taft

    Thank you for clarifying the nature of the research question about what effects reductions in wages can have on competitiveness. Even, as only a casual reader of the blog, I have seen this same theme reoccur on multiple occasions and was surprised when it was hauled out again. It is clear that the costs of other factors of production as well as intangible factors that constrain the ability to export successfully must also be part of the analysis. I would add that the fact that many of our export markets are also in dire straits must also be taken into account. What sectors do we think will be helped by reduced wages and exporting to where?

    To clarify the research question further, perhaps it would be useful to know more details about the precise effects of the devaluations of 1986 and 1993. I assume the effect was to reduce the cost of all inputs into traded sectors so we cannot investigate differences in input costs (correct me if I am wrong). However we could find out what exporting sectors gained and led the recovery and whether those same sectors (or similar ones) stand likely to benefit again.

    In the absence of clear answers to these questions, David Begg’s points seem to me to stand in more respectability than the economic mainstream as represented by this blog have given them. Could a non-intuitive response (in the spirit of Philip’s injunction that “there is no alternative”) be that with external demand so weak these deflationary/devaluationary policies will have little positive effect but will have the negative effects Begg talks about. So like doctors we should take a “cause no harm” approach. I know it sounds a little strange but these are strange times.

  29. Philip

    Historical experience here and abroad would suggest that real devaluations through nominal exchange depreciations seem to be viewed with less hostility by trade unions than real devaluatons through wage cuts because they believe that the distribution effects are different i.e. owners of capital and recipients of non-wage income (rents, dividends, interest etc.) absorb a bigger share of the national cut in living standards under nominal exchange rate depreciations. This begs a number of questions:

    (1) is this true?
    (2) do the distibutional effects change over time?
    (3) if it is true, how could complement wage cuts with other measures to best mimic the distributional (and competitiveness) effects of a nominal exchange rate depreciation?

    Andrew

  30. The 1986 and 1993 currency devaluations adjusted the prices of Irish exports on world markets and imports on Irish markets. It also kept inflation high for a time. Many differences apply between now and then, one of which was the extent to which product and labour markets internationally played a role in helping – eventually – Irish recovery. A so-called real devaluation now based, on wage-cutting, is a dangerous and possibly ruinous gamble. This was the point of Begg’s article. The alternative is targetted stimulus based on recovery bonds in the context of a high national savings rate (as consumers are scared to spend) and the beginnings of a strategic investment in skills, jobs, innovation, new traded services. Otherwise, we may face a missed decade like we had in the 1950s, and like Finland initially underwent in 1991-94.
    http://www.progressive-economy.ie/2009/07/dublin-consensus-rattled-by-begg.html

  31. First of all, I’d like to echo Sli Eile’s point on progressive economy. This thread and the reaction to Begg’s piece suggests that one of the key points of the ‘Dublin Consensus’ as Sli calls it, that there is no is no other way, has certainly taken hold here.

    http://www.progressive-economy.ie/2009/07/dublin-consensus-rattled-by-begg.html

    Secondly, Karl Whelan, in his other post on this topic expresses doubts about how strong the effect of reducing wages in the public sector would have on reducing private wages. I would go further, of course, and suggest that as the correlation between the two sectors is very complex and would negatively impact on domestic demand the effect of a public sector pay cut on our borrowing commitments would be minimal.

    Also, Begg makes two important points which I think have been ignored. One is that relying on boosting export through reducing wages ignores the international situation where demand for exports is dropping. The other is the public tolerance for this assualt on wages as the panacea.

  32. @Andrew: the best argument for nominal devaluations may remain Friedman’s daylight savings time argument: rather than have everyone adjust the time they do things, just adjust the clock. In this context, devaluation would not just reduce the relative price of Irish labour, but the relative price of all other non-traded Irish inputs. And I think that everyone would agree with Michael Taft that wages are not the only relevant cost, and that other costs need to come down also.

    So, to mimic a devaluation: in addition to lowering wages, do everything you can to get property prices, commercial rents etc down. Get electricity prices down. Take an axe to restrictive practices keeping legal, medical and other professional prices high. (I’ll believe that when I see it.) Etc.

    A nominal devaluation would be a lot easier for sure, if only it weren’t impossible.

  33. In relation to 1986 and 1993, these devaluations were effective because inflation did not pick up: the nominal exchange rate depreciation in each case translated into real exchange rate depreciation. (Inflation rates in 1986,1987, 1988 were 3.0, 3.1 and 2.1 percent; and 1.4, 2.3, 2.5 percent in 1993, 1994, 1995.)

    Analytically, the impact of these devaluations is very similar to the impact of an economy-wide decline in wages. The foreign-currency value of domestic wages declines (true then, would be true now); similarly, the foreign-currency value of domestically-determined prices falls (true then, would be true now); while, the profitability of those exporting firms that face a fixed foreign-currency price improves (since domestic-currency costs decline in terms of foreign currency).

    There are some differences between a nominal devaluation versus a ‘internal’ devaluation. In particular, a nominal devaluation can happen quickly and symmetrically across the economy. This is where social partnership has a potential role by acting as a coordinating mechanism to ensure that wage reductions are widespread (any individual sector may fear that a wage cut may not be matched across the economy, such that all that is achieved is a decline in its relative pay level). Similarly, the connection between widespread wage reductions and declines in domestically-determined prices is most clearly seen at a macroeconomic level, in view of the complex nature of input-output linkages in the economy. Again, a macroeconomic perspective is required to have confidence that wage reductions will map into price reductions.

    Since a nominal devaluation tends to be frontloaded (eg a one-time currency realignment), the projection is typically that inflation will rise in the future. A non-coordinated, staggered approach to wage cuts may lead to a slow adjustment process in which inflation is projected to fall for a sustained period, driving up the medium-term real interest rate. Again, social partnership has a role to the extent it can contribute to the front-loading of adjustment.

    In turn, there are fears that a decline in the nominal price level and nominal wages will hurt those with heavy debt burdens. However, this is also true under a nominal devaluation approach, to the extent that a significant fraction of loans are in foreign currency (as a lot of Central and Eastern Europe is finding out.)

    There may well be pyschological barriers to nominal wage reductions, as might be explained by the behaviourial economics school. However, in part, this can be addressed by leadership on the part of the social partners to explain why nominal wage reductions are part of the recovery process.

    In summary, real devaluation is standard, textbook Keynesian economics for a member of a monetary union. It seems to be me that the ‘risky’ strategy is to deviate from this approach by resisting real devaluation. There is also no trade off between real devaluation and pursuing productivity growth through improving innovation systems and related initiatives. In relation to the financing of public spending on such productivity-related initiatives, the implementation of a proportion of the McCarthy Report recommendations and public sector pay cuts may create some fiscal space to do more on such investments. However, debt-financed extra spending must fall within the ‘risky’ category in view of the already-large deficit (markets care about the total liabilities of the State, even if some of the liabilities may take the form of a recovery bond) and the pressures on international bond markets from the large projected increase in public bond issuance around the world.

    In relation to the poor state of world trade, this reinforces the importance of improving competitiveness, in view of the more intense competition in international markets.

    In relation to

  34. I think it is helpful to consider the cases of East Germany and Finland alongside each other. Both were subject to large unemployment shocks in the first half of the 1990s. Finland went through a real devaluation, and, while it took many years to bring its unemployment rate back to a reasonable level, it had fallen to a comparatively acceptable 6.8% by 2007. In contrast, unemployment in former East Germany, in currency union first with former West Germany and then with the whole Eurozone improved much more slowly. It was still at 15.1% in 2007 despite high levels of westward migration.

    While average pay in former East Germany is significantly lower than that in former West Germany, the literature I have read attributes the high unemployment levels in former East Germany mainly to labour market rigidities (including sectoral pay agreements) that prevent a big enough gap from opening up to allow labour markets to clear.

    I think the parallels with Ireland are obvious.

  35. @ Donagh
    Beyond labels such as the “Dublin Consensus,” the choice within the Eurozone and its benefit of very low interest rates etc, is to cut public spending or raise taxes more.

    Wages in the public sector are relevant if, besides security and pension benefits, rates are much higher for similar grades than in the private sector.

    So is a further big rise in taxes the best way to restore demand in the economy?

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