Ignore Competitiveness?

Wolfgang Munchau in the Financial Times argues that competitiveness is not the real problem of Southern Europe and that internal devaluation is not the solution. Paul Krugman disagrees with him and argues that the evidence is clear:

1. Prior to the crisis, inflation was higher in Southern Europe.
2. These countries displayed large current account deficits, a sign of an overvalued real exchange rate.

I have presented arguments before that support Wolfgang Munchau’s conclusions. Let me repeat some of the arguments and show additional evidence.

Unit labor costs grew faster in Spain or Greece or Italy than in Germany. But Germany was the outlier here. The behavior of unit labor costs in some of the countries in Southern Europe was not too different from that of France or the Netherlands. Here is a chart from an earlier post.

It is correct that Greece, Spain and Ireland saw higher increases in unit labor costs during the 10 years of the Euro. But the difference is small compared to France or the Netherlands. For example, comparing Spain and the Netherlands the difference is about 5 percentage points over a decade. This is not a large number given how volatile exchange rates are.

Estimates of unit labor costs are very imprecise and maybe they are not capturing the true loss in competitiveness of these economies. So why don’t we look at the outcome? What about the current account balance? Countries like Spain or Greece run large current account deficits during these years. Isn’t this a proof that they had lost competitiveness? Possibly, but there are other potential explanations for a current account deficit, such as an increase in spending fueled by a real estate bubble. It is not clear how to tell the two stories apart but here is a piece of evidence that I find useful. What happened to exports in Spain during all these years? If the story of lack of competitiveness is true one might expect that exports did not behave well during this decade as unit labor costs grew too fast. But the data reveals the opposite pattern. Compared to France or the UK (just to pick an outsider), Spanish exports grew faster during the last 10 years.

Does it mean that competitiveness is not a problem? No, but it might be a small factor compared to many other factors that have led these economies to the crisis. And if this is true, focusing on internal (or external, via exit from the Euro) devaluation as the solution to the crisis might distract us from dealing with the real issues.