Tuesday, 14 May 2013

Are labour costs all that matters in reducing prices?

A month ago, Eurostat published the 2012 data concerning labour costs in the EU. Attention should be drawn to the following graph:

(Click to Enlarge)
As the reader may observe, of the crisis-ridden countries, only Ireland is (barely) over the EA-17 average, while the rest of the countries, although they have been accused of high labour costs and the need for a more competitive economy are facing much lower costs than the "stronger" economies of Europe. Then, in the following chart we can see the change in labour costs compared to the change in real GDP for 2012.

Although not many data can be seen above, it is the case that a decrease in labour costs and a decrease in GDP go hand in hand, although labour costs appear to be lagging with respect to GDP change (see Italy or Cyprus). Economic theory states that for a nation to become more competitive, it either has to decrease its costs of production or depreciate its currency. In the Euro Area case, the second option is unavailable, thus the "need" for the first. Nevertheless, too much emphasis on the reduction of labour costs does not yield good results. 

It is doubtful that anyone would dare state that Greece or Portugal or Spain are more competitive than Germany. Yet, German labour costs were 30.4 per hour compared to €14.2, €12.2 and €21 respectively. If a person knowing just the economic theory described above and the labour costs per nation was told that Germany was the leading exporter in the EU then he would be rightly confused. It is not that Germany has a weaker currency either. In theory, a euro is a euro anywhere in Europe (well, other than Cyprus, that is).

Thus, since Germany is the leading exporter of goods it does either of three things:
1. Buys raw material at cheaper prices
2. Has a better reputation and creates better goods
3. Sells with less profit

Better reputation and quality of goods is not a thing that can be attributed to labour costs. On the contrary, when workers are paid better, it is to their best interest to create better goods. Thus, decreasing labour costs would not assist in neither better reputation nor better quality. Selling with less profit may be an issue, yet it is one we will never find out, as finding out what the profit margin of every company in Greece or Germany is, appears impossible. Then, all we are left with is producer prices. According to Eurostat, Germany's industrial producer price index (which indicates changes in the ex-works sale prices of all products sold on the domestic markets of the various countries, excluding imports) stood at 108.4 compared to 112.9 for Greece, 111.8 for Spain and 111.1 for Portugal. 

The producer index signifies that the German producer is able to purchase goods at lower prices than his Spanish or Portuguese counterpart. Rising prices do not have to do just with labour costs though. If we assume that raw materials are bought at the same prices (i.e. oil, ferrous and non-ferrous metals, etc) given a world-wide market, then all we have left are procedures, costs and productivity. Thus, of the constituents of prices, the only one which is influenced by the state of the economy is costs; which at the end does not even matter that much. 

Productivity is wholly different subject though. Eurostat calculates labour productivity per hour worked per year and the results are impressive. Germany's stands at 42.3, while Portugal's at 16.8, Italy's at 32.5, Spain's at 31.3 and Greece's at 20.3. This means that a German worker actually produces more than double of what a Greek or a Portuguese one does. As a result, the labour cost of a worker in Germany is approximately the same as for a Greek worker if we account for the fact that the former produces more (with the added advantage that the German firm produces more). 

Thus, the issue is not how to decrease wages, but how to to make workers produce more. This is not an easy subject. The main issue here is what makes a worker produce less. Is it because he is just lazy or because the whole system does not allow for more production? If obsolete equipment and stagnant procedures are to be blamed for this (again, as economic theory states), then a renewal of equipment and less bureaucracy would benefit the economy more than any reduction in labour costs would. If all workers in a country were lazy then we would not have any production at all, thus, although it is true that some people are lazier than others, the case is that if you have to work, you will eventually become as productive as your job requires you to be or as productive as it allows you to be.

We can all agree that a contraction in GDP leads to lower labour costs. Yet, we should not forget that it also leads to lower demand and thus less income for any firm. In addition, increasing productivity is a much better way to lower labour costs, increase production and subsequently income. Thus, although the current focus is on decreasing everything that may be decreased, the state of events indicates that this approach has been on the wrong: if productivity is increased then any periphery country may be able to sell more goods, both in the domestic as well as the international market, at a much lower price with much greater profit.

The quick lesson is this: if productivity is increased via increased investment in new and better equipment, then both effective labour costs will be lowered and the country's output as well as the firm's profitability will be increased.


  1. My (datafree) guess is that the main difference in per hour productivity between say Germany and Greece/Portugal lies in the mix of jobs on offer (eg, higher proportion of engineering jobs). If you'd compare similar jobs I'd think that the gap would tighten significantly.

    Other factors, in no particular order
    - shorter working hours in Germany: 35-40h, rigorously enforced; but people do apparently work harder
    - shadow economy: statistics might count the hours worked, but not the remuneration
    - infrastructure/red tape: things might flow slightly easier in Germany (but dont count on it)
    - technology: you mentioned that one; is probably true in some cases, but not always; besides, technology can be bought, so it might more be actual processes

    1. Even if the mix of the jobs was different, it would not have any effects on way productivity is measured by Eurostat (they measure on output, which means that e.g. less engineering jobs would mean less proportion of output by engineers). To be honest, my opinion is that due to the (extremely) large government sector in Greece people did not do as much work as they should have.

      Shorter working hours may be an incentive to work more but what would be a good question is whether there is productivity-based remuneration in Germany (or quantity-based) since that would provide an incentive for higher productivity.

      The statistics do not count remuneration, however, it is irrelevant to it as discussed in the start of my comment. Red tape is a problem in most South countries and very few steps have been taken to remedy for that.

      Technology is an issue when resources are spent not in improving or buying a new one but on perpetuating what you currently have due to lack of resources.

    2. I dont understand your first point- if Germany was a country of only auto builders earning €100/hr, and Greece a country only of olive farmers earning €20/hr, then the labor productivity measures would show €100 for Germany and €20 for Greece, no?

      In Germany there is little productivity based remuneration I believe (and studies have shown that those can be counterproductive anyway, cf bonus debate), but there is peer pressure not to slack too much.

      Your last point is clearly an issue, but I wonder how big the effect in reality is. Also, new technologies need new qualifications (and fewer, more highly paid resources) so a quick transition, especially in an environment with high unemployment to start with, is dangerous

      PS. Blogspot comments suck; it does not remember who you are. Is this the same on Wordpress if you are not logged in?

    3. Productivity is measured as output not salary. E.g. if 5 cars worth of 10,000 euros each were produced in a year by 1 worker working 100 hours then output would be 5*10,000=50,000 and


      If in Greece 10,000 euros worth of olives were produced by a worker working 20 hours then again productivity would equal 500. So the wage does not really matter on productivity as it does not enter the equation. What you are saying is labour cost.

      Technology obviously depends on the sector. It would be terrible to not obtain the latest hardware if you are a computer company yet not so much if you are producing steel. Nevertheless, the former's cost of replacing is much lower than the latter's. A transition is never a problem for the firm per se, but it is a problem regarding personnel's adjustment to new technologies (just think the frustration every time users have to change an operating system).

      On your P.S.: Yes, it is the same with Wordpress