Is the rebalancing of peripheral Europe a structural

of ULC growth

In this section we take a deeper look at the determinants of the competi-tive improvement of most peripheral countries by deconstructing the ULC growth into its main components.³ Through this method we can as-sess whether the competitive gain is due to long-lasting structural changes in productivity or to temporary causes like wage compression or (the) various changes in employment protection mechanisms. The latter component is important in explaining the different adjustment

3 In order to assess the international competitiveness of a country the Real Effective Exchange Rate (REER) might be a better indicator. Nevertheless, we prefer to use ULCs for two reasons: first, REERs do not allow to disentangle the effect of the different com-ponents of the index; second, in terms of competitiveness gaps among countries the two indicators display a similar dynamics.

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paths since 2008 because in some countries the employment reduction during the two crises has been strongly mitigated by wage guarantee funds, which allowed for employment adjustment by reducing the num-ber of hours worked rather than that of persons employed.

The average number of hours worked (k) is then an important de-terminant in ULC adjustment at times of crisis. In order to explicitly take account of its effect on the ULC dynamics, as shown in Box 4.1, we de-construct the growth rate of the latter into that of labour compensation, hourly labour productivity and average number of hours worked and assess their contribution for the main peripheral countries (Greece, Ire-land, Italy, Portugal and Spain) vis à vis Germany.

Figure 4.6 shows the ULC growth rate since 1999 and that of the three components. In the period 1999-2007 we can see that the German im-provement in ULC with respect to peripheral countries is due to the combined effect of improvements in hourly labour productivity and moderate wage dynamics. In the years up to 2003, the effect of the Agen-da 2010 reforms, which introduced forms of temporary employment with a lower load in terms of hours worked, is visible but this effect is of minor importance with respect to the combined effect of wages and productivity. Among the main peripheral countries, with the partial ex-clusion of Greece, the loss of competitiveness was caused by a sustained wage growth coupled with substantially flat productivity dynamics.

From 2008 on, as we have seen previously, there has been a partial catching up in cost competitiveness since Germany started to increase wages at a faster pace and ULC grew on average by 2% every year while in all troubled countries, except Italy, ULC growth has been on average negative. This result, which is particularly important for Greece and Spain, is, in any case, due mainly to the internal devaluation effect on wages. As we can see in Figure 4.6, the main change with respect to the pre-crisis dynamics is wage growth. The Greek case is the most striking one since the dynamics of ULC has been entirely driven by the wage compression effect in the last three years, while productivity growth was null or even slightly negative. In Ireland and Portugal, we find only weak signs of increases in productivity between 2008 and 2012 and ULC growth turned again positive in 2013 due, for the former, to a productiv-ity reduction, and for the latter, to the return to a positive wage growth for the first time since 2010.

IN SEARCH OF A NEW EQUILIBRIUM.ECONOMIC IMBALANCES IN THE EUROZONE

Spain is the only country where productivity improvements played a major role, together with the flat wage dynamics, in the ULC reduction.

This is because in Spain the adjustment through the reduction in the av-erage number of hours worked was of minor importance and unem-ployment rose up to 26.2% in 2013, with a youth unemunem-ployment rate above 50%. In Italy, on the contrary, the reduction in the average num-ber of hours worked contributed to the continuous deterioration in ULC in 2009 and 2012, the two negative peaks of the crises; however, the main contribution came from the wage growth, which, contrary to the other countries of the group, was positive in most of the recent years so that the expected reduction in ULC did not materialise.

To sum up, in recent years the recovery in cost competitiveness of most of the peripheral countries is mainly due to the internal devalua-tion effect since we do not observe, except for Spain, substantial changes in the productivity dynamics. The competitive gain is likely to be, by consequence, only temporary and ULC will rise again with the recovery of GDP and employment, as the Portuguese and Irish cases have already shown. Given the high level of unemployment in Spain, its performance might deteriorate in the coming years with the recovery of the economic cycle.⁴ The implied conclusion is that imbalances are likely to arise again in the coming years since restrictive fiscal policies and the related eco-nomic dynamics caused only a recession-induced competitive gain, and the structural problems of peripheral countries remain still mostly un-solved. Lacking resources for investments, due to the necessity to con-solidate public finances, the countries’ potential output will deteriorate, and the divergence in the competitive positions within the euro area and with respect to the US, most likely, will continue for the years ahead.

4 In the last months Spain, and to a lower extent Portugal, implemented deep re-forms which might be effective in bringing about an improvement in their structural competitiveness. Positive signals come in particular from the reduction of ment during the second and third quarters of 2014. Nevertheless, since the unemploy-ment rate is still very high and public finances are not yet in order, such positive signals must be taken with caution. Important improvements have also been implemented by the Irish economy. In the next future Ireland should probably not be considered a pe-ripheral country anymore.

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Box 4.1. Unit Labour Cost Decomposition

Since the average number of hours worked k is the ratio of total hours worked (H) to total employment (E), we can express employment as:

k H

E= / (1)

and consequently, total labour productivity becomes:

H k TLP GDP*

= (2)

which represent the product between hourly labour productivity (HLP) and average hours worked.

Since ULC is the ratio of the average compensation to labour productivi-ty, by using equation (2) we get a formulation of unit labour costs that includes k:

because this expression is multiplicative, ULC’s growth rate can be ex-pressed as the difference between the growth rate of the numerator and that of the denominator of equation (3):

p

According to this formulation, ULC (competitiveness) rises (falls) when the wage growth is positive or when productivity growth is negative; in addition, an increase in k will improve competitiveness since a more in-tensive use of labour resources boost total labour productivity.

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