Labor-cost competitiveness and the Eurozone — a textbook fairytale

9 Feb, 2016 at 22:03 | Posted in Economics | 1 Comment

Heiner Flassbeck and Costas Lapavitsas spell out their version of what is roughly the neoclassical textbook model of a currency union. Their main point is that there would not have been large unsustainable current account imbalances within the Eurozone, and consequently no sovereign debt crisis in the deficit countries, if all member states had kept their nominal wage growth equal to labor productivity growth plus 2% (the inflation target). Professor Wren-Lewis (2016) has been making the same point …

All this talk about labor-cost competitiveness diverts attention away from the real problem of the Eurozone: the common currency and monetary unification have led to a centrifugal process of structural divergence in terms of structures of production, employment and trade … This centrifugal process has been fueled and strengthened not just by the surge in cross-border capital flows following the introduction of the euro, but also by the common currency itself as well as by the centralized and uniform interest rate policy of the ECB which up to 2008 was perhaps appropriate for stagnant and low-inflation Germany, but was undeniably out-of-sync with inflation levels in Southern Europe … Cheap credit in the South created unsustainable asset bubbles and facilitated untenable debt accumulation which fed into higher growth, lower unemployment and higher wages—but (totally in line with market rates of return) all concentrated in the non-dynamic and often non-tradable sectors of their economies. German wage moderation mattered a lot, not through its supposed impact on cost competitiveness, but via its negative impacts on (wage-led) German growth and inflation, which in turn prompted the ECB to lower the interest rate in the first place.

The consequent crisis of the Eurozone is a deep crisis of inadequate aggregate demand in the short run and unmanageable structural divergence between major member states in the long run. Hence, the real questions are: how to bring about structural convergence between member countries of a common currency area (so far lacking any meaningful supranational fiscal policy mechanisms) in terms of productive structures, productivity levels, and ultimately incomes and long-term living conditions? What is the appropriate interest rate for the structurally divergent “core” and “periphery” if it has to be one-size-fits-all? And how can banks, the financial sector, and capital flows be made to contribute to a process of convergence (rather than divergence)? There are no simple answers and it is easy to yield to sheer “pessimism of the intellect.” But unless progressive economists source the “optimism of the will” and start seriously addressing the real issues, rather than rehashing myths about unit-labor cost competitiveness, the future of the Eurozone looks very bleak indeed.

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