WAGE-PRODUCTIVITY GAP: WHERE IS IT? Miguel Lebre de Freitas 1
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1 WAGE-PRODUCTIVITY GAP: WHERE IS IT? Miguel Lebre de Freitas 1 INTRO Competitiveness is a rather complex concept. In a broad sense, it refers to the extent to which a nation provides economic agents with (socially-aligned) incentives to produce and invest. For a moment, however, let s focus on a narrow concept of competitiveness, related to wage costs. In particular, let s stick with a definition proposed by Olivier Blanchard (2007), who refers to competitiveness as the inverse of unit labour cost (ULC) in tradable goods sectors relative to the corresponding world value. In its influential paper, Blanchard (2007) argues that competitiveness in Portugal deteriorated significantly since the mid-nineties. According to the author, this reflected a misalignment between wages and productivity growth, which caused profitability in tradable goods sectors to shrink. However, Blanchard did not provide evidence supporting the claimed loss of competitiveness. The author showed that economy-wide ULC increased in Portugal faster than in the EU15, but he did not distinguished tradable goods (T) from non-tradable goods (N). The European Commission (2011) goes along with the same argument: Since the introduction of the euro, Portugal has experienced significant real exchange rate (REER) appreciation vis-à-vis its trading partners, due to wage growth largely outstripping productivity advances (Graph 3). However, Graph 3 in the document only displays economy-wide real exchange rate indexes In a contrasting view, Campos e Cunha (2008) argues that there is no room to claim a loss of competitiveness (...) (p.158). This author explored the idea that, in a small open economy, the real exchange rate and aggregate demand are two sides of the same coin. In the well functioning case, an aggregate demand expansion translates into higher N-prices, while T-prices are bounded to remain unchanged. This causes a real exchange rate appreciation that has nothing to do with wage-productivity gaps. Fagan and Gaspar (2007) explore this idea in the context of an endowment economy where, by definition, there is no such a thing as competitiveness. Competitiveness and the real exchange rate do not necessarily go along. FORMAL To illustrate this, let s look at the real exchange rate index based on nominal unit labour costs. By definition, ULC=W/a, where W refers to the compensation per employee ( nominal wage ) and a refers to Gross Value Added at constant prices per worker ( productivity ). Now, assume that the production function is a Cob-Douglas with labour-output elasticity equal to and let Z be a variable measuring the wage-productivity gap: Z= a/(w/p)= P/ULC. When computed in terms of a base year (the constant disappears) the index 1/Z is labelled Real Unit Labour Cost (RULC) or real wage gap. In a frictionless economy, Z=1. In a world with frictions, in face of a wage push, firms may opt to maintain a higher level of employment than that implied by the textbook wage-productivity rule. When this is so, the producer margin shrinks (Z<1). Using the definitions above, the real exchange rate index based on nominal unit labour costs (RER-ULC) becomes ULC/ULC*=(P/P*)(Z*/Z). This means that RER-ULC accounts for two effects: wage-productivity misalignments (Z*/Z) and the increase in the relative price of nontradable goods (P/P*). In a well functioning economy there are no wage-productivity misalignments, so Z=Z*=1. Still, unit labour costs may increase relative to abroad, whenever non-tradable good prices increase relative to abroad. This means that we can hardly rely on 1 Universidade de Aveiro and NIPE. afreitas@ua.pt. 1 1/30/2012
2 RER-ULC as an indicator of competitiveness. Competitiveness a la Blanchard is accounted for by the component (Z*/Z) and in the proportion corresponding to tradable goods, only. EVIDENCE Returning to Portugal, we now look at the data. In Table 1, se see that between 1995 and 2010 there was a significant real exchange rate appreciation, either measured in terms of RER-ULC or in terms of relative price deflators (RER-P). As we just showed, the difference between these two indexes captures the real wage gap in Portugal relative to the real wage gap abroad (relative RULC, line c). As shown in the table (see also Figure 1), most of the RER-ULC appreciation along was accounted for the relative price effect, RER-P. The distance between RER-ULC and RER-P peaked up at 6% in 2005, to decline to 3% in Definitely, this is too small to support the usual narrative, that Portugal faces a huge problem of wage competitiveness. It should be noted that the measure Z*/Z accounts for both domestic developments and developments abroad. As for developments abroad, during this period Germany was recovering from excessive wages that came along with unification. This helps explain the decline in the EU15 labour share (e) between 1995 and 2005 (see also Figure 2). As far as Portugal is concerned, a branch level inspection in Figure 3 reveals that most of the (small) increase in the labour share along is accounted for weird developments in the sectors of building construction and agriculture. In these two sectors, indeed, wage bills increased well beyond productivity. I suspect, however, that this is more a statistical artefact mirroring the decreasing informality in these sectors - than evidence of dysfunctional wage setting 2. In any case, in the sectors of manufactures and services, real wages have evolved quite in shape with productivity along the entire period. Because these two sectors account for the bulk of gross value added in Portugal, with no surprise the share of labour on domestic income (d) remained pretty constant: at the aggregate level, there is no evidence of wage productivity mismatches. If there is any, I m missing something. Figure 3 also offers an illustration of what is behind the recent process of real exchange rate appreciation: as prices in services increased faster than prices in manufactures (which are more exposed to international competition), unit labour costs increased faster in services than in manufactures. In the aggregate, average prices and average unit labour costs increased faster than abroad, but this reflects mainly the increase in the relative price of non-tradable goods, rather than the emergence of sizeable wage-productivity gaps. Figure 4 completes the evidence. The figure plots the price deflators of exports and imports and also the implicit price deflator of the domestic production selling to the domestic market (that is, GDP minus exports; this includes tradable and non-tradable goods). The figure reveals that export prices and import prices have evolved close to each other, while prices of domestic goods sold in the domestic market increased much faster on average, until This reflects the increasing prices of non-tradable goods. Of most importance, note that along the pattern started to reverse: the relative price of non-tradable goods was already declining. WHAT HAPPENED? All in all, the evidence suggests that Campos e Cunha was right: relative price effects, rather than dysfunctional wage setting explain the recent process of real exchange rate appreciation. This accord to the widely accepted narrative that at the origin of the current external imbalance is the once-and-for-all shock consisting in the liberalization of capital inflows followed by EMU 2 Note that in agriculture and in building construction, the role of labour unions is much less prominent than in manufactures and some services. 2 1/30/2012
3 accession: this triggered the aggregate demand and pushed the relative prices of non-tradable goods above the level that is consistent with the internal and external balance. The story has to be however completed with the oil shock that marked the dump phase: Portugal is highly vulnerable to oil prices and after 2000 the relative price of oil increased sharply. As it is well known, in a small open economy a terms of trade deterioration is equivalent to a negative Dutch Disease: the relative price of non-tradable goods has to decrease to restore the external balance. Unfortunately, the opposite has happened 3. SO WHAT? It may be argued that this discussion is irrelevant: after all, a real exchange rate appreciation impacts negatively in the current account, irrespectively as to whether it comes through an increase in the relative price of non-tradable goods or through wage-productivity misalignments. For policy purposes, however, the distinction is very important. Indeed, if the real exchange rate appreciation was a consequence of the dysfunctional wage setting institutions, one would be tempted to question whether Portugal would be able to sustain its membership in a low inflation club like the euro-area. If, as it appears to be the case, the real exchange rate over-valuation is wage-gap free, then there are no reasons to conclude - at least by now - that nominal wage rigidities will impair the ongoing process of macroeconomic adjustment: after all, the return to external balance involves the re-allocation of labour across industries, which necessarily entails the celebration of new labour contracts. This does not mean that the average wage in the economy will not decline. In general, a white collar to blue collar metamorphosis will involve the acceptance of lower wages. Not only because average wages are lower in manufactures than in services, but also because recycled workers will lose the value of whatever specific knowledge they acquired in the job they had before. Hence, we shall expect workers to resist the move until it becomes a matter of personal urgency. In this context, a policy of reducing wages in existing contracts (for instance, extending the number of working hours per day or of eliminating bank holidays) will hardly encourage workers to move from non-tradable good sectors to tradable good sectors. Moreover, the evidence above clearly shows that the factor income shares are well in shape with the historical levels, so a redistribution of income from labour to capital would not make any sense. Yet the IMF proposal of easing the social security contributions and offsetting this with an increase in VAT rates fits well, at least theoretically, in the diagnostics: to the extent that such policy leads to a fall in labour costs, it would rise profitability in the tradable goods sectors and most important it would speed up the fall in prices of non-tradable goods, thereby promoting the required expenditure switching. The later effect would only hold, of course, if there was enough competition in non-tradable goods sectors, so for the lower labour costs to pass through to consumers; it also presumes that any increase in VAT rates to assure budget neutrality would apply mostly to tradable goods (in this respect, the recent VAT increase on restaurants was a policy mistake: at this stage any change in consumer prices should induce a expenditure switching away from tradables, not the other way around). In any case, in the current circumstance, with already very high VAT rates, achieving a budget-neutral increase in VAT to finance a cut in social security contributions would be a very risky exercise. We conclude by emphasizing the pervasive role of non-price barriers to factor mobility. We mean those barriers lying on the path of entrepreneurs and job-seekers that impair investment 3 In an ongoing work with Miguel Faria e Castro, we find that the recent oil price shock accounts for roughly one half of the current misalignment in the Portuguese Fundamental Equilibrium Real Exchange Rate (either measured in terms of RER-P or RER-ULC). 3 1/30/2012
4 and are delaying the re-allocation of labour from N to T. This includes skill mismatches, geographical mismatches, imperfect competition and legal frictions. From the policy point of view, the MoU correctly address some of the issues: more competition, lower frictions in the labour market, a more effective judicial system, etc. In a word, competitiveness, broad sense. But more important than all this, it is urgent to anchor the investors expectations on a scenario of fiscal, monetary, political and social stability. Without confidence, investment and employment will not recover and the Portuguese economy will meet a long and painful adjustment process. REFERENCES Blanchard, O., Adjustment within the euro: the difficult case of Portugal, Portuguese Economic Journal 6(1): Campos e Cunha, L., Is the Dutch disease pandemic in the South? In Francesco Franco (ed.), Challenges Ahead for the Portuguese Economy, Imprensa de Ciencias Sociais, Lisbon. European Commission, The Economic Adjustment Programme for Portugal, European Economy: Occasional papers 79, June. Fagan, G., Gaspar, V., Adjusting to the euro. ECB Working Paper Series, Nº716, January. Table 1: Real exchange rate indexes and adjusted wage share (a) RER ULC (b) RER P (c) Relative RULC (d) Labour share (Port) (e) Labour share (EU 15) Source: own calculations using the AMECO database. Note: (a), (b): Real exchange rates: performance relative to the remaining EU15; (c)=(a)/(b); (d), (e): The adjusted wage share is computed as the ratio between compensation per employee and gross value added per worker. The wage rate is obtained as the compensation per employee, while the average productivity is obtained as the ratio between gross value added and total employment. The procedure assumes that self-employees earn a wage that is similar to wage earners. 4 1/30/2012
5 Figure 1: ULC and P-based real exchange rates (1995=100) RER ULC (Performance relative to the rest of EU 15) RER P (Performance relative to the rest of EU 15) Relative RULC (GVA) Source: AMECO Figure 2 Adjusted wage share: total economy (compensation per employee as percentage of GDP at factor cost per person employed.) Portugal European Union (15 countries) EU15 (incl. West Germany) Source: AMECO. The wage bill is obtained multiplying the compensation per employee by total employment. The procedure assumes that self-employees earn a wage that is similar to wage earners. The implied estimate of wage bill is then divided by nominal GDP at factor prices to compute the labour share on national income 5 1/30/2012
6 Figure 3 GVA price deflators and unit labour costs by branch of economic activity GVA price deflator and unit labour costs Price defl: agriculture, forestry and fishery products Price defl: Building and Construction Price defl: Services Price defl: Manufacturing industry Price defl: all branches ULC: agriculture, forestry and fishery products ULC: Building and Construction ULC: Services 110 ULC: Manufacturing industry ULC: all branches Source: Own calculations using the AMECO database. Unit labour costs are obtained as the ratio between compensation per employee and the GVA per worker at constant prices. Figure 4: Price deflators (Q1 1995=100) (a) Exports (b) Imports (c) GDP (d)=(c) (a) Production to the domestic market (e )=(d)/(a) Relative Prices I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III I III Source: National Accounts. Production to the domestic market is defined as the domestic demand minus imports or which is the same GDP minus exports. The price deflator of this aggregate is obtained as the ratio between its nominal value and its real value. 6 1/30/2012
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