The German competitiveness dogma (part II)

I have explored some of the consequences of Germany's obsession with competitiveness in my posts The German competitiveness dogma, part I and The Blueprint of Labor Reforms in Greece: Germany's Agenda 2010. 

More evidence is appearing on the particularly damaging effects of the 'structural' competitiveness reforms closest to the heart of the Merkel government, namely the reduction of unit labor costs by way of nominal wage cuts and the liberalization of labor markets, which, in a recessionary environment caused by draconian austerity, results mainly in firings. Not surprisingly, the 2012 edition of the Employment and Social Development review of the EU commission finds that the Southern eurozone countries that had to implement these competitiveness measures in return for European financial 'assistance' seem "trapped in a downward spiral of falling output, fast rising unemployment and eroding disposable incomes." Since 2007 "the unemployment rate gap between the North and the South has widened from 0% in 2007 to 7.5% in 2011".

Evans-Pritchard correctly diagnoses a "demand shock as the real culprit" of these developments and concludes that the evidence "subverts the central claim of Europe's austerity mandarins that labour reform will somehow, magically, deliver recovery..." He already sees half of Europe in a great depression, "less acute than it was for the same bloc of states in the early 1930s but more protracted and ultimately deeper." He goes on to criticize the ECBs monetary policy as still too tight for most countries in the eurozone, implying that a looser ECB monetary policy would help lower the external value of eurozone export goods and thus lead to more exports and growth. This is the nominal devaluation approach toward higher competitiveness.

In this post, I'd like to focus on the German competitiveness approach via internal, real devaluation by way of wage reductions and labor market reforms. There are three main reasons why Germany will not support a nominal devaluation of the euro: First, because high-quality German export goods are not very price-sensitive (as recently admitted by Olga Wilde, Speaker of the German Industry Association). Second, because a nominal devaluation would awaken the inflation zombie by way of higher import prices. Third, because it would devalue the substantial amounts of euro-denominated savings deposits and other financial assets held by Germans. And so, the preferred German approach toward higher competitiveness rests on the internal, real devaluation of export prices mainly through labor cost reductions via cuts in nominal wages and non-wage labor costs (social security contributions) as well as general downward pressure on wages through the liberalization of the labor market.     

Underlying the German competitiveness doctrine are several faulty assumptions:  first, that the nominal cost of labor is the only determinant of export prices and export demand which is non-sense and without any scientific foundation [1]. Second, that nations compete against each other like big corporations. Paul Krugman, international trade expert and Nobel prize winner in economics, pointed out already in 1994 that this view is flatly wrong (see "Competitiveness: A Dangerous Obsession"): "The economic woes of countries cannot be attributed to 'losing' on world markets".... "The result of this obsession with competitiveness "is misallocated resources, trade frictions and bad domestic economic policies."

Looking at economic developments in Germany, it is abundantly clear that Krugman's claims are fully borne out by the evidence, as shown in my post on the Agenda 2010: the massive reallocation of resources away from Germany's internal market resulted in a dramactic worsening of living standards for the German population, with broadbased declines in real wages, the creation of a low-wage sector, and the widespread use of precarious employment contracts depressing general wage levels in Germany. Furthermore, Germany's bad domestic economic policies led to trade imbalances vis-à-vis other eurozone members and trade frictions with its non-European trading partners: the effective internal devaluation of German tradables resulted in mounting trade surpluses and is largely responsible for the huge economic imbalances that are at the root of the euro crisis. Currently, Germany's chronic trade surpluses causes trade frictions with the United States where Germany's competitiveness drive is viewed as a "free rider strategy, which relies on exploiting global demand rather than generating it at home," thus creating trade imbalances that are disrupting the global trade structure" (see The Telegraph: "Germany displaces China as US Treasury's currency villain"). 

At this point, it is important to recall that the Great Depression of the 1930s was caused by competitive currency devaluations as each country attempted to generate growth through exports. This provoked a vicious circle of retaliatory trade protections which eventually led to a complete collapse of international trade. The strategy to generate exports in a declining market through competitive devaluations became known as "beggar-thy-neighbor" policies as exports could only be generated at the expense of other countries.

Are we moving down the same destructive path ?  I believe, we may:

- On January 4, 2013, Bloomberg reported that "the world's developed nations are stepping up efforts to weaken their currencies"....While Japan's newly elected Prime Minister Shinzo Abe called for aggressive central bank action to boost growth and inflation, Switzerland has successfully blocked the appreciation of the Suisse franc, and the US Federal Reserve is continuing quantitative easing (monetary expansion through the purchase of Treasury bonds).

- On January 16, Bloomberg reported that eurozone chief Jean-Claude Juncker's complained of "a dangerously high euro": Russia warned that "the world is on the brink of a fresh currency war".

- Germany's Merkel government continues to impose nominal wage reductions in the Southern eurozone periphery, and structural labor market reforms designed to depress general wage levels and thus enhance competitiveness. This is nothing else but a competitive internal currency devaluation with similar export price and demand effects as a competitive nominal currency devaluation.

The competitiveness doctrine obsessively imposed in the eurozone and elsewhere will depress global demand and growth if every country follows it !

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[1] Unit labor costs, i.e. nominal labor costs per unit of output which is the standard measure of competitiveness, can also be reduced by an increase in output (the ratio's denominator). While holding labor costs (the numerator) constant, output can be increased through productivity enhancements which in turn can be achieved by investing in human resources (education, work training) and the tools they work with (investment in research and development). Such investments would have the added benefit to increase aggregate demand, employment, and economic growth !