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.

Should the Crisis last?

Although I have yet to see any decisive action from politicians and policymakers in the EU I have the notion that from 2013 the situation will be better for the Union. I base this on the current actions by private banks, which are either selling their non-core loans or trading their existing loan portfolio in a country, in order to deleverage themselves (for details read this). I would assume that banks, tired of waiting for the officials to act, have decided to take action into their own hands. 

What worries me more than overcoming the crisis, is overcoming it without the opportunity to learn something from it. If the crisis terminates and we have the banks to thank, what would politicians and policymakers have done about it? Practically nothing. At the same time nothing will be done to safeguard the Union's future, as no extra authority will be given neither to the ECB nor the European Council. If the same causes provoke another crisis in the future nothing will be able to halt it at its beginning, since no measures have been taken now.

If the crisis ends without any political (or government) intervention then politicians will understand that they need to do almost nothing to correct the situation: procrastination, austerity measures and maybe a stimulus package will be more than enough. It would also mean that Southern Countries, with their productivity to the low end of the EU average will have done nothing to correct the situation. Cyprus, Portugal and Italy will continue to see their people work more than everyone else, alas, with lower productivity. You may notice that I exclude Greece from this. In my opinion Greece will be the nation which will mostly benefit from this situation. It is the only nation which has been through the process of reorganizing its finances, cutting excessive spending and making reforms and structural changes in its economy. Although the speed of this process is not one which would allow it to witness less contraction and unemployment, the process itself will be beneficial for the nation, something which will be more visible in the next 5 years. Nevertheless, had the process been slower the negative effects would have been less now, with the positive ones still occurring. (this scenario is of course based on the assumption that Greece will be given the extra €2.5 billion it will need this year, and will remain both within the Union and the Eurozone, which it should!)

On the other hand, Cyprus, Portugal and Italy have done little yet to correct this situation. Although all countries have undertaken measures to reduce their fiscal deficit (which is good if they are aimed at reducing irrational expenses), I have not yet seen one take any measures to increase productivity. What we so far witness is tax increases, salary cuts and reductions in pensions. All of which are mainly aimed at the older population!

As for the youth? It seems that no country has so far taken any action towards reducing youth unemployment or implementing incentives to increase start-up creation.  Have a look at youth unemployment in the EU (source: Eurostat)

Both the EU-17 and the EU-27 youth unemployment are over 22%! And nothing is yet to be done about this situation. I am guessing that until a change of mind occurs to the heads of politicians and policymakers, no change will occur in the EU. Well, I hope that the crisis lasts enough for them to make that change.

Do we need a Crisis?

When people face difficulties, it is always easier to blame someone else for their mishaps. When a nation views its own problems, and as nations are governed by people, it is more than easy to criticize and assign fault to others. The same has happened now, as many Northern Europeans believe that the responsibility for the crisis lies only on the shoulders of Southern Europeans who, "do not work enough".

This, however, couldn't be farther from truth. Although South Europe is portrayed in the media as a place where everyone is constantly partying and nobody is working this seldomly depicts real life in the South. Germany on the other hand has the reputation of being a hard-working country. Still, German working hours are amongst the lowest in the world. So is France's. Look at the following chart comparing work hours in the OECD countries:

So what happens here? Are the poor Greeks and Italians working hard the whole time but the bad Germans take the GDP from their hands? In all fairness, no. It seems that although South Europeans are working many hours, what they lack is productivity. A quick glance in Wikipedia may help: Italy, Greece and Cyprus have below average productivity. Specifically, in the case of Cyprus and Portugal, their productivity is much lower than the EU average.

The only difference, is mentality. While Germans and French work less, their time put to better use and thus their productivity is greater. On the other hand, whilst Greeks, Italians, Cypriots and Portuguese work many hours, they do not do much in that time. The big question here is why? Is it just that they sit around and do nothing all day? I hardly think so (although many civil servants in the South are accused of doing so). The problem here lies in the heavily bureaucratic systems, with many anachronistic rules, laws and perceptions. The legal systems in Cyprus, Greece, and Italy were graded by Moody's as some of the worst in the EU, whilst Portugal's was merely average. Spain's on the other hand was very good.

This is why the South is in need of a crisis. A change in mentality and institutions is essential. Greece has only begun to realize these changes and the effect is disastrous. People are never ready to rapidly move from one mentality to another as this would mean a change of the world they live in. In the words of Olli Rehn: "And even in Greece, more has been achieved than is often realized."

This is one reason I state that change should be slower than it is now. Humans do not enjoy change. The labor force has been shown to be more resistant to change than anything else, surprisingly more than capital! (By capital one means things like machinery, plant and equipment). This reminds me the frog anecdote: If a frog is put in hot water then the frog jumps right out. If the frog is put in cold water and the water is heated slowly until it reaches the same temperature as the hot water from before, then the frog stays in and gets boiled.

The case is the same with measures: Move too rapidly and people will revolt. Take change slowly, allow people to adjust to it and you will have much better results. If you don't trust me just take a look at Greece nowadays!