Internal Wage Devaluation – Over the past few years, the IMF has repeatedly warned against the policy of too much fiscal austerity. The IMF’s research department in particular has published several analytical papers pointing to the perverse consequences of fiscal austerity on economic activity and jobs. Even if, at the level of individual Euro Area countries, the IMF did not really change its concrete approach, the IMF did insert these alternative messages on the dangers of fiscal austerity into the policy discussion at the European level.
At the same time, the IMF’s thinking on the policies of wage austerity and structural deregulation has evolved very little. The formal line is still that, with fiscal austerity being detrimental to growth, economies need to improve competitiveness by pushing wage dynamics down, in this way replacing falling domestic demand with an expansion of external demand.
However, a box published in its latest World Economic Outlook on the nature of current account adjustments that have been taking place in individual Euro area member states makes interesting reading. The analysis in this box allows to put serious question marks around the policy of internal wage devaluation that Euro Area member states are pursuing. (See here: http://www.imf.org/external/pubs/ft/weo/2013/02/pdf/text.pdf).
At first reading, the text box does not depart from traditional IMF analysis. Its formal conclusion is still that distressed Euro Area member states have to intensify their strategy of wage devaluation since the improvement in their current account balances is mainly ‘cyclical’ and due to the domestic demand squeeze spilling over into highly reduced import demand. Put simply, the IMF is saying that if (and this is a big ‘if’) Greece, Spain or Portugal see a revival of demand growth dynamics, then deficits on their current accounts would quickly reappear, hence raising the question whether markets would be willing to finance these external deficits.
This being said, a closer look at the IMF box reveals that its graphs and analysis can actually be used to tell a completely different story, a story pointing to the failure of the policy of internal wage devaluation which the European Commission, the ECB and the IMF itself have pushed for.
This story is somewhat hidden in the graph below, taken from figure 1.3.3 of the IMF’s box. It shows the IMF’s estimates of the different factors that have been shaping the cumulative export performance of the different member states over past years.
The main driver of exports appears to be the import demand from the rest of the world outside the Euro Area (the red bars). This is true for all member states, Germany included, but with Greece (and to a certain extent France as well) being the exception.
Another force contributing positively to export performance is the evolution of the nominal effective exchange rate (the green bars, in other words the (trade weighted) depreciation of the euro currency up until the last quarter of 2012.
On the other hand, internal wage cost adjustments are hardly playing any role at all. Their contribution should normally show up in relative GDP deflators, an indicator measuring the relative evolution of price levels of individual countries. However, these bars are hardly visible on the graph.
So what the IMF is saying here, although in an implicit way, is that the strategy of the troika to squeeze wages in order to improve price competitiveness and increase exports is not really working. The internal devaluation strategy does show up in falling wage costs and/or wages in Greece, Portugal, Ireland and Spain but it does not show up in explaining export performance, as measured here by the IMF.
How to explain this finding that wage cost compressions up to 20% (Greece) are hardly driving export performance?
Why Does Internal Wage Devaluation Not Work?
Here, the argument that trade unions have been making all these years on the dangers of a de facto coordinated policy of wage depression becomes extremely valid. In an integrated European internal marketplace, one country’s domestic demand represents another member state’s export potential. Squeezing wages across a sizeable part of the Euro Area will also squeeze overall demand dynamics, with imports and exports between Euro area countries going down. In the end, it does not help much to try and improve competitive wage or price positions if export markets are stagnating since wage squeezes are being widely applied across the internal market.
Another graph, taken from the same IMF text box, allows to illustrate this process. For each member state it shows the cumulated real growth in export demand coming from the Euro Area on the one hand and from the rest of the world on the other hand. One can observe that export demand originating from the Euro Area has basically been stagnating over the entire 2008-2014 period. For Portugal and Italy, exports into the Euro Area have even fallen substantially. Given the rounds of wage and fiscal austerity that have been applied across broad parts of the Euro area, this does not come as a big surprise.
It is exports to the rest of the world, where demand was not suffering (at least not to the same degree) from the consequences of wage austerity, which have ‘saved the day’ and secured some growth in total exports for the countries concerned. Here, Portugal and Spain have outperformed other Euro Area countries whereas Greece experienced stagnation on this category of exports as well.
However, even here it can be doubted whether the increase in exports to the rest of the world is to be attributed to wage cost moderation. If so, this would have shown up in the IMF estimates from the first graph and we would have seen a more sizeable contribution to export performance coming from the GDP deflator bar in this graph. It is more likely that, given depression of domestic demand as well as depressed import demand in the Euro Area, economies have simply shifted productive capacities which otherwise would have been left idle towards export markets and export opportunities that are outside the Euro Area.
In a nutshell, the path of wage devaluation that has been chosen by the European ‘Masters of Austerity’ is not only dangerous because it is triggering serious disinflation and possible deflation (see here). On top of that, the IMF is now showing that wage devaluation is not even leading to what is supposed to be its primary goal that is to trigger a revival of export demand based on improved price/cost competitiveness.