Some Thoughts on Wages and Competitiveness

There’s a lively debate going on about Philip’s earlier comments about competitiveness and recovery and I wanted to add to it but then wrote something so long I decided it would be best to exploit privilege and start a new post.

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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.

Ireland is Internationally Competitive: Guest Post from Ronnie O’Toole

The ESRI’s analysis as released last week contains a very useful emphasis on the fact that Ireland’s Current Account deficit is fast approaching zero. However, the report also contains a seeming inconsistency, arguing as it does that that the current account imbalance is proof that Ireland has a substantial competitiveness deficit (page 2).

If both are true, could this mean that the vanishing deficit is proof that the competitiveness problem has dissipated over the last year or so? Ok, not necessarily, as the reason could be that a structural competitiveness problem could be temporarily masked by unusually high household ‘recession’ savings.

However there is another explanation. A CA deficit can come about with a very large domestic imbalance, even if a country has no external competitiveness problem. Does this simple description accurately characterise the Irish economy in 2009?

Finding out which explanation is more likely can be helped by decomposing the structure of the CA deficit that had emerged by 2007. In other words, we were importing more than we could afford for some reason – can examining those same imports help us understand why we were importing them?

Most imports go into intermediate production, so it is not easy to link each import with an ultimate end use. However using the CSO input-output tables allows us to estimate pretty well where imports were ultimately destined.

Such an IO analysis results in a stark conclusion. In 2000, final demand for GFCF induced imports of €10bn. By 2007, this had risen €8bn to €18bn. The large scale construction activity was pulling in a huge amount of imports which (ultimately) we could not afford. Add in the imports from construction workers spending wages etc, and it is very easy to see that the scale of growth of importing linked to construction could easily explain the vast bulk of the €10bn deficit that had emerged by 2007.

In contrast, while imports for the export sector increased (allowing for income repatriation), exports increased at a far faster rate. The net contribution of exports in 2000 was €21 bn, by 2007 this had risen to €33 bn.

This does not seem to be consistent with the view of an economy that had by 2007 supposedly developed a chronic competitiveness problem. Other measures would back this up – consider the UNCTAD’s measure of inward investment, which put Ireland second only to Singapore in 2007 (see NCC report).

As the construction boom source of domestic demand disappears, so too has the deficit, and well before any cost measures could possibly have an effect in terms of improving our trade performance. This is happening before our eyes in the trade figures, yet the virtually unanimous view of the Irish economic community that Ireland has a chronic competitiveness problem remains. This view is actually based on very little data – relative CPI/wage indices over the last decade or so. Without knowing where we stood competitiveness-wise at the start of this period, or relative productivity since, this proves very little.

Does all this logic (if true) change the current ‘competitive devaluation’ policy proscription much? Possibly not. The domestic imbalance is so large that a very large stimulus will be needed to reduce unemployment once again. However, if I am right, and Ireland is far more competitive that generally believed, then the upswing when it comes might be more dramatic and persistent than we could think to hope for as of today.