In November 2015, the IMF released an IMF Staff Discussion Note (SDN/15/22) – Wage Moderation in Crises: Policy Considerations and Applications to the Euro Area – which purports to measure “the short-run economic impact of wage moderation and the implications for policy in the context of the euro area crisis”. It juxtaposes the impacts of the so-called internal devaluation approach with the impacts of Eurozone monetary policy. It recognises that the euro zone countries cannot use exchange rate depreciation to boost domestic demand but argues that instead, “lower nominal wage growth … and lower inflation or higher productivity growth relative to trading partners is needed”. The paper presents the standard mainstream arguments that: 1) wage cuts improve employment through increased competitiveness; 2) interest rate cuts stimulate overall spending; 3) quantitative easing stimulates overall spending. There is very little empirical evidence to support any of these statements, especially when fiscal austerity is accompanying these policy measures. The discussion does acknowledge wage cuts may be deflationary and “work in the opposite direction of the competitiveness affect”, in other words, domestic demand and overall growth declines. The unstated message is that internal devaluation doesn’t really improve competitiveness when it is imposed across the currency bloc and undermines domestic spending, which further impedes any export growth (because domestic income drives import demand).
The IMF paper conducts an experiment whereby it conducts a simulation where there is a:
… a coordinated, exogenous 2 percent reduction in wage (and price) inflation …
They compare the results of imposing that policy on a single Eurozone nation against imposing it on “all crisis-hit economies (which account for some 30 per cent of the euro area total GDP)”.
They also compare these experiments under conditions where the interest rate can fall to offset the declining demand from the wage cuts against a situation where monetary policy is constrained by the so-called ZLB (zero lower bound) interest rates.
They conclude that when interest rates are at their lower bound, wage cuts in the crisis-hit nations undermine real GDP growth in the entire Eurozone.
When monetary policy is constrained by the ZLB, the IMF claim that quantitative easing (QE) can provide a stimulatory policy intervention to offset wage cuts.
I should warn readers that the underlying simulation model (EUROMOD) used by the IMF has a number of assumptions that I believe render its results rather suspect.
I will leave it to those who are interested to explore that issue further.
Essentially, the IMF simulations claim that:
1) “The more countries undertake wage moderation together, the smaller is the competitiveness effect and the larger is the demand effect and thus the smaller the benefits and the larger the costs of wage moderation for these economies.”
2) “In the case of a single euro area crisis-hit economy undertaking wage moderation alone, the net result on output is strongly positive”.
3) “… when all euro area economies moderate their wage and price growth by 2 percent, this action results in a loss in output by about 1 percent by the third year. Put simply, the positive competitiveness effect is now even weaker and the negative demand effect so much stronger that it pulls down output below baseline. The reason for this outcome is that euro area economies trade to a large extent with one another: intra-euro area trade accounts for nearly half of total euro area trade, and euro area countries nowadays exchange goods and services equivalent to about 20 percent of euro area GDP per year”
Now if we took the logic in Point 3) then one could easily argue that with inflation so low in the Eurozone, these results would suggest that an across-the-board wage increase in the Eurozone would have strong positive impacts on growth without undermining any relative competitiveness for any particular nation.
The IMF, of course, doesn’t take the reader down that interpretation of their results because the paper is really designed to justify the existing policy of wage cutting and so-called ‘structural reforms’, which are really about undermining working conditions, job security, Occupational Health & Safety regulations, and other things that make work more tolerable.
It is interesting that their model considers exports and imports to be dependent on the real effective exchange rate (REER).
Consider the following graph, which shows the movements in monthly – Effective exchange rate indices – (REER) as produced by the Bank of International Settlements (BIS).
You can learn about this data from their publication – The new BIS effective exchange rate indices – which appeared in the BIS Quarterly Review, March 2006.
There was an earlier publication – Measuring international price and cost competitiveness – which appeared in the BIS Economic Papers, No 39, November 1993.
Real effective exchange rates provide a measure on international competitiveness and are based on information pertaining movements in relative prices and costs, expressed in a common currency. Economists started computing effective exchange rates after the Bretton Woods system collapsed in the early 1970s because that ended the “simple bilateral dollar rate” (Source).
The BIS ‘real effective exchange rate indices’ (REER) adjust nominal exchange rates with other data on domestic inflation and production costs.
The BIS say that:
An effective exchange rate (EER) provides a better indicator of the macroeconomic effects of exchange rates than any single bilateral rate. A nominal effective exchange rate (NEER) is an index of some weighted average of bilateral exchange rates. A real effective exchange rate (REER) is the NEER adjusted by some measure of relative prices or costs; changes in the REER thus take into account both nominal exchange rate developments and the inflation differential vis-à-vis trading partners. In both policy and market analysis, EERs serve various purposes: as a measure of international competitiveness …
If the REER rises (falls) then we conclude that the nation is less (more) internationally competitive.
The graph shows the movement in real effective exchange rates for various Eurozone nations plus Iceland. The two periods are from 1999-2007, that is, the Eurozone period before the crisis; and the period from 2008 to 2015 (October).
I included Iceland because it suffered very badly in the crisis but has its own exchange rate. The bars indicate the percentage change in the REER over the two periods.
The degree of real wage cutting in the sample of nations shown has been quite different in the austerity period. Real wages have been undermined by a combination of nominal wage cuts and tax hikes (for example, the VAT increases in various nations as part of their austerity packages).
Most nations have not cut nominal wages (greece is the standout with wage cuts of between 15 and 25 per cent depending on how one measures it).
Comparing Greece with Iceland we know that according to the AMECO database, Nominal compensation per employee rose in Iceland by 42 per cent over the period 2008 and 2015, whereas they fell by 15.9 per cent in Greece.
Yet, Iceland increased its international competitiveness by more than Greece because its exchange rate depreciated.
At any rate, the graph shows that even though the REER for Greece has indicated it has increased its competitiveness, Germany has made greater gains.
The Eurozone nations tend to move in lockstep and so gains from measures that might be taken internally are lost
Please read my blog – Eurozone unemployment – little to do with international competitiveness – for more discussion on this point.
Now consider the following graph, which shows the current account balances as a percent of GDP for Germany (dark blue bars), France (red bars), and the average for Portugal, Ireland, Italy, Greece, and Spain (PIIGS) from 1991 to 2015.
The 2015 result is the estimate from the October World Economic Outlook database from the IMF. It will be close to the final outcome given the database has only just been constructed.
The German current account surplus continues to grow and now stands above 10 per cent of GDP, and is sufficient to warrant a macro imbalance finding under the capital European Commission rules against Germany. Of course nothing will happen.
The other notable feature is that the PIIGS are now as a block back in surplus after significant deficits in the lead up to the crisis.
The individual country results are: Portugal a surplus of 0.7 per cent of GDP, Ireland a surplus of 3.2 per cent of GDP, Italy a surplus of 2%, Greece is surplus of 0.7 per cent, and Spain are surplus of 0.9 per cent of GDP.
The dramatic shift in the outcomes for the PIIGS in the period after the crisis has been hailed by the Troika as the successful response to the austerity policies that were inflicted on these nations and which reduced domestic costs.
But one cannot conclude that the adjustment has been driven by changes in international competitiveness given the information shown in the previous graph.
Further, consider the next graph, which shows the percentage point change (as a percent of GDP) in the current account balance for a range of countries. The changes computed over the period 2009 and 2014 and a positive change indicates a movement towards q surplus or towards a bigger surplus.
It is easy to see how large the adjustment has been for the peripheral Eurozone nations.
The next graph looks at the average annual growth in imports of goods and services (blue bars) and exports of goods and services (red bars) for the PIIGS over the same time period.
This graph provides us with a better understanding of what has been happening in the peripheral economies of the Eurozone.
All of the current account adjustment that has occurred in Greece has come from the dramatic decline in imports, which is an income affect driven by the Depression that the Troika has imposed on the economy.
It is clear that export growth has on average be negative over this period.
This result casts severe doubt on the veracity of the claims that internal devaluation improves competitiveness and provides a basis for renewed growth via exports.
The situation in Portugal is not dissimilar in the sense that a substantial amount of the adjustment has come from falling imports as a result of falling national income levels due to austerity. The difference is that Portugal has sustained positive export growth over this period, on average.
Only Ireland has sustained positive import and export growth over this period.
It is clear the IMF is persisting with its export-led growth mantra with wage cuts and broader attacks on working conditions being at the forefront.
The empirical evidence would suggest that in most cases this strategy is failing dramatically.
I explain why in detail in this blog – Fiscal austerity – the newest fallacy of composition.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.