Amid continued economic, financial, and political turmoil, several European Union countries are seeing improvement in a crucial measure of competitiveness. According to a new Executive Action Report from The Conference Board, the cost of labor per unit of output has fallen significantly in a number of the hardest-hit economies, led by Ireland and Eastern Europe.
For the Euro Area, controlling unit labor cost (ULC)—defined as nominal labor compensation per unit of real output—may be key to redressing the competitive unbalance between core and periphery that has haunted a continent and fueled four years of recurring crisis.
“A drop in unit labor cost is an important sign in the beginning of adjustments in Europe’s most trouble economies,” says Bart van Ark, The Conference Board chief economist and co-author of the report. “For now it is mainly the reduction in wages which leads the adjustments, but once productivity begins to increase as well, it could be the key to a more sustainable recovery.” Since states within the Euro Area cannot devalue their currencies or dictate interest rates, boosting ULC and, thus, competitiveness relative to other members of the zone can only come about through real changes in worker efficiency, he adds.
There are early signs that the rebalancing through unit labor cost adjustments is under way. While France, Germany, Austria, and other relatively strong continental economies have pursued social welfare policies to limit unemployment during the downturn—thereby reducing productivity and increasing unit labor costs—countries with more flexible labor markets in the “Anglo-Saxon” model have been able to make faster adjustments. Ireland lowered its ULC by 5.3 percent between 2008 and 2011, a success only rivaled by less mature Eastern European countries such as Hungary, Latvia, and Lithuania, which still retain their own currencies. Elsewhere outside the Euro Area, ULC in the United Kingdom has fallen by 3.6 percent—the sharpest decline of any large economy.
In the most troubled European economies of Greece, Portugal, and Italy, a tradition of rigid labor markets kept unit labor costs rising through the early years of the crisis. Continued weakness and deepening austerity measures, however, have recently pushed them toward turning points suggesting a strong reduction in costs and faster efficiency gains compared to the Euro Area’s northern core. In Greece, ULC rose by 4.4 percent overall between 2008 and 2011, but fell by more than 5 percent from 2010 to 2011. With its large contingent of flexible part-time workers, Spain is further along; Spanish ULC fell 4.4 percent between 2008 and 2011. Across the Euro Area, unit labor costs in manufacturing have fallen by 3.9 percent in the past two years, after rising at the outset of the crisis.
Because of the rapid shifts in unit labor cost in recent years, the German manufacturing sector has become less competitive in terms of cost per unit of output relative to the manufacturing in many other European economies—again, led by Ireland, Eastern Europe, and the United Kingdom. Dramatic reductions in workforce and compensation have propelled British firms ahead of formerly more cost-competitive French, German, and Italian rivals. Meanwhile, Ireland is now Europe’s most efficient manufacturing economy by far, ahead of even low-wage off-shoring destinations like Poland.
In contrast to manufacturing, the service sector—which is more labor-intensive with output largely composed of nontradables—remains a weak performer across Europe. Only Spain and the United Kingdom have managed to substantially lower unit labor costs in the services sector. With output falling faster than workforce or wages can be cut, Germany, France, Greece, and Ireland all saw significant ULC increases in services. The remarkable 41.5 percent decline in Irish ULC for manufacturing was largely offset by a 26.4 percent ULC increase in services.
Given the significant private and public sacrifices needed to bring down unit labor costs against an over-strong currency, an exit from the Euro Area altogether has become a tempting option for the most troubled economies. To test the consequences of a Euro Area exit, The Conference Board modeled the impact that regaining a national currency—and independent monetary policy—would have on unit labor costs in a country like Greece compared with alternative scenarios.
“The huge devaluation following an exit from the Euro Area would certainly boost competitiveness in the first year or two,” says Bert Colijn, labor market economist for The Conference Board Europe and co-author of the report. “But these effects would quickly evaporate, as the subsequent recovery in labor compensation in the medium- to long-term outpaces GDP growth. Hollowing out labor costs can only do so much. Lasting competitiveness gains must ultimately come from the productivity side of the unit labor cost equation.
“For this reason, we found that neither a troubled economy nor the Euro Area as a whole is likely to benefit in the long run from a unilateral exit, or a wider breakup, or the status quo of muddling through,” says Colijn. “Ultimately, the best outcome for competitiveness is achieved with greater fiscal integration, including a banking union and Eurobonds, that will encourage the sort of investment needed for productivity, innovation, and competitiveness that is substantive and sustainable.”