Friday, 23 August 2013

Eurozone's nominal rigidities

In an article published in the Journal of Economic Perspectives, Kevin O'Rourke and Alan Taylor examine Eurozone's ongoing depression and focus on monetary adjustments and Eurozone-wide automatic stabilizers that could supposedly help Europe in its painful recovery, suggesting a full-pledged banking union and a stronger consolidation of Europe's institutions. What caught my attention was the brief look at nominal wages and employment in four peripheral economies during the length of the crisis. The authors found an interesting pattern where nominal wages seem to have risen during the crisis (everywhere except in Greece), while employment was (and still is) falling. In Ireland, despite claiming to have performed an internal devaluation wages have been rather stagnant. However their employment slump was stopped in 2012. 
Source: O'Rourke, Taylor (2013): "Cross of Euros" JEP 27(3):167-92.

What could this be a signal of? First of all, as Fatas and Mihov in their article on VoxEU suggest, it could be a signal of a structural change and a "new normal" in the economy, where unemployment is likely to remain high for quite some time.

Source: VoxEU
Fatas and Mihov analyzed US recessions and recoveries in the past 60 years and calculated how costly recessions can be in terms of output loss, either because of the initial depth of the recession or the subsequent slow recovery. (Read the whole paper here.) The two worst recessions in terms of output loss were the 1981 recession (11.72%) and today's (2008) recession (22.10% and counting). In 1981 the US recovered much quicker than today, with output loss during the recovery being rather small. Today, even though output loss from the recession itself was lower than in 1981, the slow recovery caused the costs of the recession to rise substantially. The reason could be a misplaced approach to recovery. While in 1981 the US embarked on a series of supply-side reforms that changed the structure of the economy resulting in a new pattern of economic growth the US embarked on, today's recovery was characterized by a mix of failed approaches; extensive stimuli and bailouts followed by a wrong approach to austerity without any serious attempt to adjust the system to the global shock in addition to a range of half-baked temporary solutions. 

Another thing I believe their analysis suggests is that in these two recessions the magnitude of the shock was too large to be solved by standard macro policy tools. Which was exactly the policy mistake made by current administrations both in the US and in Europe. Even if we reject the premise of similarity between the two recessions and the applicability of recovery policies, the pattern of the current recovery clearly suggests that something is different. 

Does this mean European countries should succumb to being stuck in a low equilibrium with high unemployment rates? Probably for some time, especially if the pace of reforms remains the same as it is now. Europe, with its rigid structural system, is far beyond any form of stimuli. It is in desperate need of change as it has failed persistently to adapt to the new technological and consequential structural shocks that have hit the global economy and changed the patterns of trade and cross-country specialization. 

As for the competitiveness side of the story, will the rapid decline of nominal wages really help Greece gain competitiveness? It will as much as would a return to a depreciated Drachma - so, not very much. And in Greece, with prices of public services going up, the decline of real wages is even worse. But if Greek wages are falling while other Eurozone countries have their wages rising, shouldn't this suggest that Greece is gaining at least relative competitiveness? No. This argument would be true if lower Greek wages would result in attracting more investments into the economy vis-a-vis the stronger competitiveness. But there is much more to gaining competitiveness than a decline of real wages. It also depends on the skill set of domestic workers, the levels of education, the rigidity of domestic labour regulations, domestic business regulations, the efficiency of the domestic tax system and the legal system. In none of this does Greece score high. They are making a terrible mistake for suggesting that a decline of real wages is helping the economy. Its only effect so far is shattering domestic consumption. 

Other peripheral countries (to which Slovenia has joined in) are no better. They have all used the standard macro austerity tools without offsetting some of the effects by freeing up businesses and fostering incentives for innovation. This is why peripheral Eurozone remains in a situation of a lot of pain and still no gain.

2 comments:

  1. Very interesting, thnx for the paper recommendation (ok, you get my attention as soon as you write "nominal" :D )
    Anyways, regarding the structural "side" of the problem, maybe a better indicator would be labour unit cost because it accounts for productivity too. If you look at the real wage, it sounds as if you think the problem is nominal - adjustment coming from number of hours worked (causing high unemployment). some recent papers I read indicated that Greece really did gain some advantage on the unit cost front(think the most straightforward was by De Grauwe), but as you wrote, the fact that there are no incoming investment makes bottom seem deeper in absence of other positive impulses from the reform side

    Greets

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    1. Yes, unit labour costs are a better productivity indicator, and I believe they too are falling in Greece (not so sure about other peripheral countries), however I still doubt it makes much of a difference for them

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