Tuesday, September 11, 2012

Labor Costs and the Eurozone Adjustment...

Here's Barry Eichengreen on the necessary adjustment process in the Eurozone: 

"Unless the increase in capital stock significantly raises labor productivity (which is unlikely insofar as much of the preceding period’s investment took the form of residential construction), the result is a loss of cost competitiveness.  The country then faces slow growth, chronic high unemployment and grinding deflation, as weak labor market conditions force wages to fall relative to those prevailing elsewhere in the euro area.  The temptation, then, is to leave the euro zone so that monetary policy can be used to reverse the erosion of competitiveness with a “healthy” dose of inflation."                                                                   

Now here's a chart I made showing unit labor costs in Italy and Spain, relative to Germany. It gives an idea of what adjustment the periphery countries need to make to bring themselves into line with Germany and regain competitiveness. It's for the manufacturing sector only because thats what most tradeable output consists of (not a lot of Italian haircuts sold in Germany). 
Unit Labor Costs = Labor Compensation /  Total Output 

Either real labor compensation in Italy and Spain needs to fall or output needs to expand, because labor costs obviously became seriously out of line during the "boom" following the creation of the euro in 2002.

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