Unit Labour Costs – The History of a Dangerous Metric

Tony CaseyNominal ‘Unit Labour Cost’ (ULC) is a metric widely used throughout Eurozone policy circles to justify pro-cyclical wage restraint and austerity policies that will reverse imbalances and restore national competitiveness to the deficit periphery. What evidence is there to support this persistent Eurozone policy bias?

National Competitiveness

Surprisingly, despite the widespread use of the term, national competitiveness is an extremely elusive concept with little grounding in economic theory. Writing in 1990 whilst laying out his now famous ‘Diamond Model’ of national competitiveness Michael Porter (1990) concluded “While the notion of a competitive company is clear, the notion of a competitive nation is not.” Famously, in 1994, Paul Krugman would make the same point even more bluntly that competitiveness of nations is a “dangerous obsession” and that firms compete but “countries do not” (Krugman, 1994).

In the intervening decades nothing much has changed. There is still no commonly agreed theory of national competitiveness and yet by 2011 one of Angela Merkel’s infamous national competitiveness charts using the single cost dimension of nominal ‘Unit Labour Cost’ (ULC) finally found its way into the Eurozone governance regime. In addition to the regulations and directives of the ‘two pack’, ‘six pack’ and ‘fiscal compact’, the Excessive Imbalance Procedure (EU 1174 and 1176/2011) now enshrines annual member state ‘scorecards’ of 11 competitiveness metrics, including nominal ULC.

What is ULC?

In many ways the widespread use of ULC as a proxy for competitiveness is an unexpected consequence of the design flaws of the Eurozone. Once the macroeconomic tools of interest rate and exchange rate adjustments were removed from member states’ imbalance adjustment armoury the Eurozone policy consensus shifted to one of ‘internal devaluation’ of prices, specifically labour prices and this has led to a dangerous focus on ULC.

The problem is that as Felipe and Kumar (2011) point out, the way that firms measure ULC and the way that EU scorecards measure ULC are very different. To firms ULC is 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 and firms will most certainly monitor this type of metric in their planning and investment decisions.

ULCfirm = [Total Labour Compensation] / ([Physical Output] / [No. of Workers])

However what EU scorecards are measuring is quite different. The denominator is aggregate labour productivity, calculated as the ratio of nominal value added to a price-deflator, and then this is divided by the number of workers.

ULCaggregate = [Average Labour Compensation] / (([Real Value Added] / [Price-Deflator]) / [No. of Workers])

Labour costs

 

 

 

 

 

 

The result is a dimensionless aggregate ULC metric which is not a weighted average of firm level ULC as many EU policy makers seem to think. It was charts based on this method of calculating aggregate ULC that Angela Merkel was reputed to tirelessly circulate at EU meetings in the run-up to the euro crisis showing flat ULC for competitive Germany and rising ULC for the uncompetitive rest of the EU, especially the periphery.

With some simple arithmetic Filipe and Kumar show that aggregate UCL is just the labour share in total value added output multiplied by the price-deflator and that increases in aggregate ULC over the period 1990-2007 can be explained by increases in that price-deflator. Consequently, except in Greece, aggregate labour shares have actually declined or remained constant in the other 11 Eurozone countries they analysed. The most likely cause of a rising price-deflator, they conclude was the inflation caused by massive capital outflows from the core to the periphery engendered by structural flaws in EMU design. Using rising ULC as a justification for wage restraint and austerity policies is therefore a very dangerous metric which may only succeed in driving down aggregate labour share with obvious deflationary consequences.

What is the empirical evidence that ULC drives growth?

Even if we accept the limitations of aggregate ULC as a proxy for competitiveness there is mounting empirical evidence for non-cost factors as the main drivers of competitiveness. A recent paper from Storm and Naastepad (2014) reviewing the available empirical literature and running their own exhaustive regressions on the effects of relative ULC (RULC) find “the statistical evidence on the inverse relationship between export growth and the growth of RULCs is overwhelmingly weak”.

Their reasoning is straightforward. Modern export oriented manufacturing industries have disaggregated their production techniques into Global Value Chains (GVCs) greatly reducing the Eurozone labour cost component. In fact on average ULC in the periphery PIGS (excluding Ireland) make up only about 16% of the manufacturing gross output price. Accordingly if ULC increases by 1%, the gross output price increases by just 0.18% and the effect of increases in RULC on cost competitiveness are negligible. Closer to home our very own Proinnsias Breathnach performing a similar analysis of Census of Industrial Production (CIP) data found an average labour cost component of only 10.8% in 11 examined export sectors and came to a very similar conclusion of the relative inelasticity of price competitiveness to changes in ULC for Ireland.

Turning to Germany Storm and Naastepad note that the ECB routinely decomposes Eurozone export performance into both a ‘structure’ and a ‘competitiveness’ effect. The structure effect can be thought of as non-cost factors such as a focus on quality, and the targeting of high-growth markets and export destinations. The competitiveness effect is a residual effect of the influence of price as well as non-price factors (including R&D, regulation and institutions).

The ECB find the structure effect to be far more important as a determinant of export success than the residual competitiveness effect. Accordingly, during the period 1996–2007, German exports increased by average 0.45% year on year. This success was largely the result of “(i) an advantageous export structure, geared towards rapidly growing regions including non-euro EU countries, other Eastern Europe, Russia and China and (ii) robustly growing medium-tech commodities (motor vehicles and agricultural and industrial machinery), for which world markets are growing at an above average rate.” (Storm and Naastepad, 2014)

Remarkably the ECB show that due to the structure effect alone German exports would have increased by 1.46% year on year. The fact that it was only .45% implies that Germany lost competitiveness despite declining RULC. For Storm and Naastepad the bottom line is that the exports of Germany and the peripheral countries are concentrated in technologically different sectors and different market destinations. Germany has a market share of 18% in the total world exports of the top 100 most complex products—against Italy 3.1%, Spain 0.9%, Greece 0.02% and Portugal 0.04%. Of the Greek and Portuguese exports, 33% and 22%, respectively, belong to the least complex product group. “The Mediterranean export structure (in terms of complexity) is similar to that of China.” It is largely these non-cost structural differences that explain German export success, not divergent ULC.

CompNet (ECB Competitiveness Research Network)

It is not only the academic literature that is calling into question the utility of ULC as a proxy for competitiveness. In March 2012 the Governing Council of the ECB established The Competitiveness Research Network (CompNet). The network is composed of economists from the ECB, all 28 EU national central banks, as well as from international organisations interested in competitiveness issues. Under pressure of overwhelming empirical evidence the stated objective of CompNet is to identify both price and non-price competitiveness indicators that can be incorporated into policy outlets such as ECB surveillance reports.

In a series of interim findings CompNet conclude that not only do ULC and other traditional price indicators have very low explanatory power regarding the growth in member state imbalances but “capital flows from the European core to the periphery were a cause of the divergence in ULCs between the core. . .(and the periphery) prior to the global financial crisis” (ECB and CompNet, 2013).

Although CompNet is not due to finalise its activities until mid-2015, the network is already generating interesting results in its three core work-streams of cost and non-cost indicators, firm-level studies and the effects of cross border GVCs. There are signs that these results are finding their way into a much more nuanced competitiveness policy debate than the narrow focus on traditional cost-based metrics such as ULC which has characterised policy response to the Eurozone crisis to date. Already for example a battery of novel non-price indicators of competitiveness have been developed. Prominent among these indicators are measures of the competitive benefits of focusing on product sophistication, high growth market sectors and export destinations and indicators measuring the consequences of endogenous competition pressures from the BRICs (ECB and CompNet, 2014).

It is too early to say but it is possible that the disastrous hegemony of the dangerous ULC metric as a proxy for competitiveness which has in part been used to justify a Eurozone periphery recession now in its 22nd quarter may be coming to an end with a much more holistic and nuanced policy approach. 

“Tony is a post-graduate student on the UCD Master of Public Policy program. His research interests are European Innovation, Jobs and Competition policy. This blog post was completed as part of his assignment for a module in European political economy”

References

ECB & COMPNET 2013. Competitive Research Network: First Year Results.

ECB & COMPNET 2014. Competitiveness Research Network Interim Report II: results in 2013 and plans for 2014. In: MAURO, F. D. (ed.).

FELIPE, J. & KUMAR, U. 2011. Unit Labor Costs in the Eurozone: The Competitiveness Debate Again. Levy Economics Institue of Bard College, Working Paper No. 651.

KRUGMAN, P. R. 1994. Competitiveness: A Dangerous Obsession. Foreign Affairs, 73(2).

PORTER, M. E. 1990. The Competive Advantage of Nations. Harvard Business Review.

STORM, S. & NAASTEPAD, C. W. M. 2014. Europe’s Hunger Games: Income Distribution, Cost Competitiveness and Crisis. Cambridge Journal of Economics, 28.

 

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