Should countries cut wages?

Rory O'Farrell08/04/2010

Rory O'Farrell: The current financial crisis is special in two main respects. The first and most obvious is the size and scope of the worldwide recession, leading to the first decline in global output since World War II. The second reason is that this is the first major crisis since the introduction of the Euro currency. The crisis has hit some countries harder than others, and some have lost competitiveness in the aftermath of their credit bubbles. In the past, when countries were faced with a recession and a decline in their competive position, one policy option was to devalue their currency. This made their exports cheaper and boosted their economy. However, with the introduction of the Euro, this was no longer possible for Euro Area countries, and some countries (such as Ireland) have attempted a ‘simulated devaluation’ (1) by reducing nominal prices and wages. In addition to the Eurozone which formally contains 16 countries; the three Baltic countries, Denmark and Bulgaria have their currencies pegged to the Euro, with Latvia and Denmark allowing a fluctuation of no more than 1 per cent. While this ‘simulated devaluation’ has already been applied in Ireland and the Baltic countries, pressure is being placed on southern Eurozone countries such as Portugal, Greece and Spain to follow a similar approach. Also, across Europe some employers may try to reduce wages as their firms are genuinely in serious financial trouble, and other profitable firms may simply try to take advantage of the labour market uncertainty in order to reduce wages.

Two main arguments have been put forward in favour of pursuing a policy of wage cuts.

The first is to cut public sector wages in order to improve the public finances. Some countries that had experienced credit fuelled booms prior to the recession had accrued structural deficits. This was because the credit boom gave the illusion that countries were on a sustainable growth path, and governments cut taxes or increased spending above a sustainable level. Since the credit bubble has burst affected governments are trying to close the deficit by increasing revenue by increasing taxes or by cutting spending and public sector wages. Governments must be careful not to further reduce demand but cutting the wages of those on lower incomes, who tend to spend a higher proportion of their income. Also reductions in structural deficits can be partially offset by increase capital spending, increasing countries’ potential for long-term growth.

The second main reason given for reducing wages is to ensure a competitive ‘simulated devaluation’(1). Prior to the introduction of the Euro, when countries were affected by a recession one available policy option was currency devaluation. This policy was followed by several European countries in the early 1990s and in 1992 lead to the collapse of the European Exchange Rate Mechanism (ERM). When a country devalues its currency the price of its exports to foreign markets falls. This causes its exports to be more attractive relative to competitors, leading to increased employment in the export sector. The price of imports also rise however, so consumers spend less on imports (perhaps substituting imports for domestically produced goods) as their real incomes decrease.

In parlance, with a ‘simulated devaluation’ rather than actually devaluing the currency, its effects are simulated by reducing all prices and wages in the economy. The aim is that by reducing nominal unit labour costs, and the price of other inputs, the output of firms will be more price competitive, boosting net exports. In practice however it is wages that are targeted rather than other prices such as prices for consumer goods, or intermediate inputs to businesses such as rents and energy costs. So whereas with an actual devaluation the burden is spread across the economy (though borne most by those who spend a large proportion of their income on imports) with a simulated devaluation it is workers who bear the greatest burden. As workers tend to spend a higher proportion of their income than other groups, targeting workers incomes will suppress domestic demand to a greater extent than an actual devaluation, exacerbating the deflationary pressure.

Table 1 (to improve legibility, click on table and then click again to zoom)

Table 1 gives a ranking of the relative competitiveness for real and nominal unit costs in the EU. Though nominal unit costs are frequently used for cross country comparisons they ignore that in high wage economies, firms often also benefit from high prices for their output, and high profits. Nominal wage costs would be valid for comparing the wage competitivenss of export sectors across countries if data on wages and price levels specific to the export sector was available. However, this is not the case. Real unit costs are the more relevant figure for cross country comparisons as they account for differences in the sale price achieved by firms. Real unit labour costs are identical to, the perhaps more intuitive, labour share of income, and is calculated by the formula

leading to the price index cancelling, and then adjusted for the numbers of self employed in the economy. For nominal wage costs the formula is given as

and an adjustemnt for the numbers of self employed in the economy. We can see here the crucial role of the overall price index in affecting nominal unit costs.

Table 1 compares real and nominal unit labour costs in 2003 and 2007. Eurostat’s Comparative Price Levels are used as the price index. The years 2003 and 2007 are chosen to examine changes in competitiveness from the year of accession of the New Member States to the EU and the peak of the credit fueled boom. Special attention should be paid to the Baltic States and Ireland, the countries pursuing a ‘simulated devaluation’. Between 2003 and 2007 these countries (except Lithuania) experienced a competitive drop in position with Latvia switching from 2nd to 10th position. Perhaps what is most striking however is that even at the peak of the credit boom all these countries were in the top 10 in terms of real unit costs. Workers were gaining a smaller share of production than workers in Germany, which has been held up as a model of competitiveness (The Economist, 2010). Looking at nominal unit costs (which are of more interest to export orientated firms) we see that these four countries, excluding Lithuania, experienced a decline in comptitveness in terms of nominal unit costs (4), with Ireland moving from 18th to 22nd place. The huge difference in Ireland’s comparative position when looking at real and nominal costs is due to the role of of non-wage factors in the price index, such as prices for rent, material inputs, and the supernormal profits of some firms. This would suggest that rather than focusing on wages, policy makers should focus on how non-wage costs are affecting competitiveness (5). However, policymakers are focusing on wage cuts to improve competitiveness rather than other factors.


(1) See Weisbrot and Ray (2010) for a detailed description of Latvia’s simulated devaluation and its negative effects.
(2) and (3) - see Table 1
(4) It should be noted that both real and nominal unit costs are averages for the entire economy, and do not relate specifically to the export sector, where productivity is usually higher.
(5)Wages are just one dimension of international competitiveness, and absolute wage levels are not included in the World Economic Forum’s ‘12 pillars of competitiveness’ (Sala-I-Martin, et al, 2009, pp4).

Posted in: EconomicsFiscal policy

Tagged with: subsidies on wagesCompetitiveness

Dr Rory O'Farrell     @r_o_farrell

O'Farrell, Rory

Rory O'Farrell is an economist lecturing in TU Dublin. He previously worked for the OECD and for NERI.




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